Mutual fund investors in India typically restrict themselves to active funds; passive funds are not so popular. There are only a few index funds and Exchange Traded Funds, and even they are not actively marketed by fund houses, with the result that their corpuses are not too large relative to those of active funds.

The primary difference between active and passive funds is that fund managers have no role to play in passive investing. Investors’ money is invested according to the composition of the index on which the fund is based. For instance, an index fund that tracks the Nifty 50 will invest in the Nifty 50 stocks, following the same allocation pattern as the index. Expenses charged to investors are very low in passive funds.

But there are just 23 index funds in India, with total assets of ₹2,637 crore. Twenty of them track the Nifty or the Sensex.

While there are a few index funds that track the Nifty Next 50 Index or the Mid-cap index, the corpus managed by these funds is negligible.

There are some 47 equity ETFs listed and traded in India, but here too, the choice is very limited. The size of the passive investing segment in the Indian equity market compares unfavourably with the total corpus of equity mutual funds in India.

While the absence of options and generally lower awareness may be keeping investors away, those supporting active funds in India also say that since the Indian equity markets are not yet mature, there are ample opportunities that active fund managers can exploit to generate higher returns for investors.

Efficient market hypothesis Passive investing is based on the premise that markets are efficient where information dissemination takes place to everyone at the same time. In such a market, the active fund manager is less likely to be privy to information that is not publicly available. This, in turn, makes it difficult to deliver out-sized returns.

The mid- and small-cap stocks in the Indian market operate in an inefficient ecosystem, where there is information asymmetry, which can be exploited by fund managers. Active fund management can, therefore, work well in this segment. But in large-caps, the Indian market is getting close to an efficient market, with fewer opportunities for active fund managers to exploit.

Our analysis comparing the average one-year rolling returns of index funds based on the Nifty and the Sensex with the average one-year rolling returns of large-cap funds shows that while the extent of outperformance by large-cap funds was much larger before the 2008 global financial crisis, this gap has narrowed considerably in recent times.

Also, actively managed large-cap funds have been able to deliver returns that were much higher than index funds in the early stages of a market up-cycle. The difference in outperformance, however, narrows significantly as the bull-market matures and stock valuations get pricey.

All tapped out This trend is probably applicable in the current phase of the market too. The market has been rising on a sustained basis from the bear-market low in 2009, with minor corrections in between. Most opportunities that could be exploited in the large-cap space might have already been tapped.

While large-cap-stocks-oriented funds have managed to outperform index funds when the market is in a clear-cut up- or down-cycle, managers of active funds seem to lose the plot when the market meanders sideways. Excessive churn, in an attempt to second-guess the market, seems to be hurting the returns of large-cap funds in such phases. This was observed in the period between September 2013 and January 2015 when stocks did not adopt a clear trend.

It is generally believed that actively managed large-cap funds help contain down-side risk in periods when markets fall. This too appears to be an exaggerated claim since the difference between the loss suffered by index funds and large-cap funds in the market down-cycles witnessed since 2000 is less than 2 percentage points.

The clincher: lower expenses What clinches the argument in favour of index funds, when compared to large-cap funds, is the expense ratio charged to investors. All actively managed funds can charge up to 2.5 per cent of their assets as expense while the expense ratio for index funds is capped at 1.5 per cent. The expense charged may increase depending on certain factors.

A comparison of passive funds with active funds in the mid- and small-cap space is, however, not possible since there are no index funds or ETFs based on small-caps. Investors with a greater penchant for risk can, therefore, pick actively managed mid- and small-cap funds. In terms of returns, mid- and small-cap funds win by a large margin across all time horizones, be it one, three, five, 10, 15 or 17 years. These funds have also managed to beat the Nifty 500 index by more than 10 percentage points over one-, three- and five-year periods. In terms of absolute returns, multi-cap funds come next, delivering strong returns over all time-frames.

When we looked at the extent of outperformance of mid- and small-cap funds (category average of one-year rolling return) over the Nifty 500 index’s one-year rolling return since 2000, we found that unlike large-cap funds, mid- and small-cap funds are continuing to do better than the index funds in recent times too. However, when the rolling returns of these funds were compared with the Nifty mid- and small-cap 400 index, the outperformance narrows significantly.

Due to the lack of sufficient options in index funds and ETFs to take exposure to this segment, mid- and small-cap funds are needed to add zest to your portfolio.

Also, given the higher volatility in earnings and the fact that business cycles tend to change quickly in smaller companies, greater involvement in tracking the portfolio performance is required in mid- and small-cap funds. Active fund management might, therefore, be a better idea in this segment.

It is also not correct to assume that mid- and small-cap funds inflict bigger losses during times of market falls. While this was true earlier, in recent market falls, fund managers have managed to contain declines by moving in to cash at the right juncture or through smart stock churn. For instance, in the 2008 crash, while large-cap funds lost around 50 per cent, the loss in mid- and small-cap fund category was 9 percentage points higher. But in the recent market fall recorded in 2015, while large-cap funds lost 18 per cent, the loss in mid- and small-cap funds was only 12.6 per cent.

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