In investing, people often ask if active investing can do better than the market in a consistent manner. This question is at the heart of the debate between active funds vs passive funds, sparking many conversations, studies, and decisions by investors.
In this article, we’ll explore the nuances of active and passive investing, the differences, and whether the belief that the higher costs associated with active investing could indeed be worth it for better returns holds true.
What is Active Investing?
Active investing is a proactive way to invest, with frequent buying and selling of stocks, bonds, or other securities. The goal is to outperform the stock market or a specific benchmark index such as the Nifty50 index.
Active investors or fund managers use market research, forecasts, and their judgment to make investment decisions. The goal is to identify undervalued securities poised for growth or to sell securities expected to decline.
The success of active investing is heavily dependent on a deep understanding of the market, a high tolerance for risk, and the ability to make timely decisions by fund managers.
What is Passive Investing?
Passive investing on the other hand, adopts a more laid-back approach, often described as a “buy-and-hold” strategy. You pick a big basket of stocks that reflect the overall market, like the Nifty 50 index, and just stick with them over time, hoping to mirror how that big basket performs.
The idea is that even though stock prices go up and down all the time, they usually go up over many years. So, if you spread your investments across a diversified portfolio, you can ride out the ups and downs and grow your money as the whole market grows.
Plus, because you’re not always buying and selling, you don’t pay as much in fees, making passive investing a cheaper way to invest.
The Active vs. Passive Debate
So, should you actively aim to outperform the market or settle for market-average returns at a lower cost?
Supporters of active investing believe that by carefully choosing stocks or timing the market right, investors can make more money than the market average. They think this is possible because markets aren’t perfect and sometimes there are pricing inaccuracies which creates opportunities.
Yet, many studies and financial analyses show that beating the market consistently is very hard, especially after you consider the high fees that come with active management. These fees can eat into profits, making it tough for active strategies to do better than passive ones over time.
On the other hand, Passive investing is simpler and cheaper, and by focusing on the long-term, investors can benefit from the market’s general trend upwards. Because of its simplicity, lower costs, and good performance history, many investors find passive investing appealing.
Active vs Passive: What does the data say?
Let’s look at some reports and data to find out which is better.
SPIVA, short for S&P Indices versus Active, is one of the most detailed reports on the topic. This study has been ongoing for 20 years and takes place in nine different countries, providing insights into how the investment world changes over time. It looks into regions like Latin America, the United States, Canada, Europe, the Middle East, North Africa, South Africa, India, Japan, and Australia. SPIVA checks over 100 investment categories and publishes a research report twice a year, making it a go-to source for both investors and financial experts.
For our analysis, we looked at two SPIVA reports, the SPIVA Mid-year 2023 India scorecard and the SPIVA year-end 2023 US scorecard report.
SPIVA Mid-Year 2023 India Scorecard Highlights
The Mid-Year 2023 SPIVA India Scorecard provides a detailed comparison between actively managed Indian equity and bond mutual funds against their benchmark indices across various investment horizons—1, 3, 5, and 10 years. Here are the findings of the report:
- Indian Equity Large-Cap Funds
These funds had a tough time in the first half of 2023. Even though the S&P BSE 100 went up by 7.1% during this time, ~58% of the managers of large active funds couldn’t do better than this benchmark on a YTD basis.
This trend of underperformance persists over longer durations, with 86.2% and 92.9% of active managers underperforming over 3Y and 5Y periods, respectively.
- Indian Equity Linked Savings Scheme (ELSS) Funds
The S&P BSE 200 was up 6.2% in the first six months of 2023, and just 17.5% of Indian ELSS funds underperformed the index. That doesn’t sound like a lot right?
But over the longer term, the underperformance rate rose, with 66.7% of funds underperforming the benchmark over the 10 years.
- Indian Equity Mid-/Small-Cap Funds
The benchmark for Indian Equity Mid-/Small-Cap funds, the S&P BSE 400 MidSmallCap Index, rose 12.4% in H1 2023, and 45.3% of active managers underperformed the index over that period (YTD).
- Indian Government Bond Funds
The S&P BSE India Government Bond Index rose 4.7% in the first half of 2023. Active management in this category also struggled to beat the benchmarks, with an 85.2% underperformance rate (YTD basis).
Although the rate of underperformance decreased over the three- and five-year horizons to 75.0% and 66.7%, respectively, the majority of active managers still could not surpass the benchmark performance.
- Indian Composite Bond Funds
For the first half of 2023, the S&P BSE India Bond Index rose 4.6%. The H1 2023 underperformance of Indian Composite Bond fund managers was the highest across all categories in the SPIVA India Scorecard, at 95.7% (YTD basis).
In the Indian context, the broader trend indicates a prevalent challenge for active strategies to deliver superior results, especially over longer investment horizons and in a consistent manner.
Is it the same in the US?
You can argue that this is because the Indian markets have been doing better than most of their global counterparts recently and hence the benchmark indices offer better returns in India.
Let’s look at the largest stock market in the world – the SPIVA year-end scorecard for the US;
Over the full year, a majority of actively managed funds underperformed their assigned benchmarks in most of the reported fund categories.
In 2023, 60% of all active large-cap U.S. equity funds underperformed the S&P 500.
Across all categories, underperformance rates typically rose as time horizons lengthened. At the one-year horizon, 6 of 22 equity categories and 8 of 17 fixed income categories saw majority outperformance, falling to just 1 equity category and 4 fixed income categories over five years. At the 15-year horizon in both asset classes, there were no categories in which the majority of active managers outperformed.
This report shows how the active funds are unable to consistently outperform the benchmarks in the US as well. It makes a strong case for passive investing, which is more about following the market as a whole and usually costs less, as a simpler and often better way to invest.
Data from the US market complements our earlier narrative on the Indian market, further supporting the argument for passive investing as a more predictable and often more cost-effective strategy for long-term wealth growth.
“On average, the average large-stock fund manager produces average returns before fees and below-average returns after fees. So compared with after-fee returns, an index fund is superior.”Howard Marks
Through a global lens, the evidence continues to suggest that passive investing stands as a formidable approach for those looking to participate in market gains without the added costs and uncertainties associated with active management.
Need more proof?
However, it’s not just the data that points us in this direction; a vast expanse of academic research strengthens this argument against active investing’s ability to consistently beat the market.
The wisdom of Nobel laureates like Eugene Fama and Harry Markowitz, alongside the expertise of William Sharpe and Merton Miller, casts a long shadow over the active versus passive investing debate. These economists, whose contributions have deeply influenced our understanding of financial markets, warn against the folly of attempting to time the market in response to fluctuations in stock prices. Their collective voice offers a powerful caution: the endeavor to outperform the market through active management, such as trying to predict short-term market movements, is not just challenging but likely unwise.
“The question is when is active management good? The answer is never,”
Eugene Fama, Nobel laureate at the Morningstar ETF Conference in Chicago.
Across various market environments and over multiple time horizons, a significant portion of active managers fail to outshine their benchmarks. This pattern of underperformance persists, from U.S. large-cap equity funds to Indian government bond funds, reinforcing the notion that achieving consistent value addition through active investment strategies is a daunting task.
So, you tell us, active investing or passive investing? Which one do you prefer now?
Sources
Spiva India Scorecard Mid Year 2023
Spiva Persistence Scorecard US Year End 2023
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