Does investing in actively managed mutual funds make sense?

Actively managed mutual funds are supposed to beat their benchmark indices. If the index returns 10%, an actively managed mutual fund should return more than 10%. Similarly if the index loses 10%, the fund should lose less than 10%. You pay a small management fee to the mutual fund for managing your money and outperforming a benchmark index. Else why them money for their services; you could well buy an index fund which is passively managed.

For the uninitiated, in an actively managed fund, the fund manager creates a portfolio and buys and sells stocks depending upon his/her judgement, experience, ability and skill. In contrast, in a passive fund, the portfolio mimics a particular index, the stocks and the percentages in the portfolio are the same as those in the benchmarked index.

So do actively managed funds actually beat their respective indices?

Consider the Nifty-50 index that comprises 50 large cap stocks.

Over the last 3 years, the Nifty has risen at 23% compounded (as on 22 August 2008 day end).

Over the same period, only 22 out of 108 diversified equity funds that have existed for more than 3 years have given a return higher than 23%!

86 out of 108 funds have not been able to beat the Nifty index.

That's 80% of all such funds!

So why should the management fee be paid for managing money?

The percentage is similar for returns over 1 year. 82% (152 out of 184) diversified equity funds could not even garner a return of 5.1% given by the Nifty.

There are reasons for such underperformance. But the end result is, that over the last 3 years, 80% actively managed diversified mutual funds have not been able to beat the common index.

A similar trend exists in developed markets as well. For example, in the USA, 80% funds fail to beat their benchmark indices.

Mutual funds often become victims of their own success. When a particular fund outperforms, a lot of fresh money flows into it, chasing past performance. With larger assets under management, maintaining the same level of performance becomes difficult.

When mutual funds as an industry becomes too big, they tend to become a sizeable portion of the markets themselves. It then becomes difficult to beat the market since mutual funds start representing, in a very significant manner, the market itself!

Add to that the management fees and transaction costs. That takes away a little from the returns. At least in India, management fees are small. In the USA, this is not always the case.

The famous investor, John Bogle, an ardent advocate of index funds and does not think actively managed mutual funds can outperform an index over a long period of time.

In India, over the longer run, actively managed mutual funds have indeed beated the Nifty and the Sensex. For example, over the last 5 years, 41 out of 61 funds beat the Nifty returns. But one has to understand that mutual funds have proliferated in the last 3-4 years. There are only a handful of funds that have existed for over 10 years! Mutual funds that have a long history have been much smaller in size earlier. It is easier to beat an index with lesser capital under management. Size often becomes a hinderance for success.

Also, over the last 5 years, till 2005, midcap stocks that go seriously undervalued during the period 2000-2003, gained more than largecap stocks. Moreover, an economic upturn helps the performance of smaller companies more than those of larger companies.

Consequently, most funds outperformed the Nifty during the period 2003-2005.

Three years ago, actively managed mutual funds could easily have been declared superior to index fund investing. But in view of their recent underperformance compared to index investing, the jury on whether investing in actively managed mutual funds is better than passive index funds investing, is still out.

Only time will be the judge!