Active vs passive: How investors can choose the right fund strategy

Active and passive funds offer different advantages across market-cap segments, making a mix of both a sensible portfolio strategy

A recent Morningstar India report titled Active/Passive Barometer India shows why investors should look beyond recent numbers when choosing between active and passive mutual funds. Active funds’ success rates varied sharply across market segments and periods. The success rate measures the share of active funds that beat their passive peers. 

Largecap performance fades 

Largecaps’ strong one- and three-year results weakened over 10 ye­ars. Stock picking has become cru­cial amid divergence in performance over the past 18-24 mo­nths. “Fund managers who pick stocks that are doing well and avoid the others can outperform,” says Anil Ghelani, head – passive investments & products, DSP Mutual Fund. 

Index heavyweights weighed down the Nifty 50 and Sensex. Active managers underweighted them. “They also drew on the Nifty Next 50 constituents to outperform,” says Anup Bhaiya, founder, Money Honey Financial Services. 

Largecap indices led earnings growth during 2000-2021, while the broader market’s earnings have grown faster over the past five years. “Stronger growth outside the segment creates opportunities for active managers to generate alpha,” says Prateek Agrawal, managing director (MD) and chief executive officer (CEO), Motilal Oswal Asset Management Company. Only 25.8 per cent of active largecaps beat passive peers over 10 years. “Market efficiency, portfolio constraints and costs make sustaining alpha difficult,” says Harsh Vira, founder and CEO, FinPro Wealth. 

Midcap managers struggled 

Midcaps’ reasonable one-year sho­wing faded over three and five ye­ars. Ghelani says midcaps are no longer under-researched. Inflows lifted the entire segment, benefiting indices like the Nifty Midcap 150. 

Many stocks with stretched valuations, thin earnings or heavy debt rallied. “Active managers who screen for balance-sheet stre­ngth, cash flows and promoter track records avoid them,” says Harsha Vardhana VM, founder and group CEO, Atom Financial Services.  Inflows caused fund sizes to balloon. “Larger funds find it harder to build or exit positions without moving prices,” says Vardhana. 

Smallcaps’ mixed results 

Smallcap funds’ strong one-year showing dipped over three years before recovering over five. Smaller, weaker companies led during the three-year period, hurting funds that held sensible portfolios. “Broad benchmark momentum or microcap rallies can temporarily favour passive indices over active managers who screen for earnings quality and governance,” says Bhaiya. 

Use success rates with care 

Success rates reflect past, not future, market conditions. Investors should not rely solely on them. Vira suggests that investors who use the­se figures should give greater weight to five- and 10-year numbers. 

Match choice to temperament 

Besides performance, investors’ risk appetite should govern the active-passive choice. Active funds suit investors who can tolerate underperformance. “Conservative investors anxious about lagging the index are better suited to passive funds,” says Abhishek Kumar, Sebi-registered investment adviser and founder, SahajMoney.com. 

Use a mix across categories 

Experts suggest using a mix of active and passive funds across marketcap categories. “Market efficiency, breadth of opportunities, and dispersion between companies differ across large, mid and small caps,” says Aparna Shanker, chief investment officer (CIO), equity, The Wealth Company Mutual Fund. Prefer passive funds in the largecap segment, where intensive coverage and institutional participation make it difficult to sustain alpha. Market inefficiencies and wider opportunities favour active stock picking in the midcap and smallcap segments. “Manager quality, risk controls and liquidity management matter more in these segments,” says Shanker. Shanker suggests that the core portfolio should hold low-cost broad-market passive funds. Active funds should be held in the satellite portfolio. “This structure balances core stability with tactical opportunities for higher growth,” says Kumar. 

The writer is a Mumbai-based independent journalist