Passive vs active investing: Which is a better option?

I am a believer in the power of equities to create wealth and change life outcomes for investors. But I believe there are few reasons which prevent investors from benefiting from the power of equity investing.  The most important one is the inability to keep patience and understand the nature of cycles. Equity markets are cyclical and hence equity investment products’ return profile is inherently cyclical.

For those of us who have studied physics or basics of engineering, we know that a cycle is represented by a sine wave; a wiggly line going along a central axis meandering up and then down like a wave, weaving through peaks and then troughs and then troughs followed by peaks again.

But if we keep in mind that this is a sine wave whose central axis is inclined 45 deg up, that would save us a lot of trouble and emotional turmoil in the process of investing. Anyway, the intersection of physics and multi-disciplinary thinking applied to equity markets is a topic for another day.

One of the key reasons preventing investors from creating wealth in equities is lack of awareness and appropriate education about equity investing from neutral third parties in absence of any product related agenda. Usually over the years I have seen that when AMCs educate investors or intermediaries on a topic there is a product agenda behind it. That apart AMCs tend to communicate in a very complicated manner. “51% of all active funds have underperformed the index over the last 1 year” is an example.

“This is time to go over-weight midcaps is another”; “Value will out-do growth” or “accommodative stance of the RBI has opened up a window for duration strategies” is another…apart from the inherent complexity of the message, I hope you can see there is a product message loaded in each of these statements and distributor “training” programs that follow.

The discussion around promoting passives basis alpha or the lack of it is one of futility and wastefulness for precisely the same reason. It is of little relevance in the investment matters of the uninitiated where they are looking for basics around getting started in the process of building their pot of wealth to achieve certain goals while industry personnel load their prescient but irrelevant convictions and beliefs on these investors.

The biggest dis-service to development of passive products in India is done by the obsessive debate throwing around data on alpha or the lack of it. To say you will have no alpha basis recent performance is the absolute equivalent of promoting equity products basis past performance and both do equal harm to the process.

I recently came across one AMC that promoted passive products to a large institution because in 2018 for exactly one year the markets were “polarized” and hence broad based active funds found it difficult to beat the Nifty which ran up basis a 1 lakh crore infusion from the EPFO and poor economic growth resulting in performance getting concentrated in few stocks and sectors.

Eventually 2018 passed, 2019 came. Post the budget came a series of Fridays, the polarization started getting depolarized and the institution left wondering what happened!

1. Isn’t it obvious that if there is no alpha eventually at some point in time investors will move to passives?

2. There is already a plethora of passive choices available on direct to customer platforms which will result in greater availability and acceptance of passive products, won’t passives automatically end up showing higher in the descending sort on returns; especially when these platforms have no human intervention of AMCs or their intermediaries.

3. Isn’t it perilous to make conclusive statements about index capturing the whole market and its opportunities before the markets themselves capture the economy, why worry about maturity of markets before the economy matures?

We live in a country where the first insurance company got listed a year or two back! And similar other sectors…such sectors have NIL representation in frontline indices and infinitesimally small representation in broad market indices.

I think there is a lot more to passive products which is not as obvious as the alpha discussion…let the process play out and while the alpha story is destined to play out, we don’t need to wait.

1. Asset allocation as the prime contributor to outcomes – there are studies and there is evidence which says that bulk of the returns and outperformance vis-à-vis investment goals come from being in the right asset class as opposed to being in the right fund in any asset class.

For instance, its obvious that in 2019 if you were in the best of Indian equity funds that was not as good as being in an ordinary US index fund or say a gold as an asset class.

For instance in 2016 being in the mid cap index was far more relevant than being in the best managed large cap fund in India. So if one understands that being in the right asset class is more important than fretting over the best fund or its alpha generation abilities then one would anyway spend time on asset allocation and execute it through the right passive basket.

2. Simplicity of buying the asset class – related to the above is the fact that once you decide to make allocation to chosen asset classes after understanding their correlations and risk – return dynamics, its easiest to execute by buying the representative passive basket instead of buying an actively managed basket which runs the risk of “over-doing” and resultantly at times, for lack of correct wording, “under-doing” the asset class for you.

3. Simplicity of having no one to blame and nothing to compare in hindsight – in any case when the going gets bad, there is a lot of hand wringing and “what went wrong”, “who goofed up” analysis with equity investing, lesser number of reasons provided to investors to get into hindsight mode the better it is.

Again related to the above points is the fact that once a decision is made to execute asset allocation through the representative basket, the only hindsight comparisons or heart-burn if any is never related to being in the wrong fund with the wrong fund manager but only about the level of exposure to a particular asset class and the behaviour asset classes vis-à-vis each other and vis-à-vis the ability of the investor to achieve her goals.

When it comes to people obsessing over choosing the right funds, the distraction of being in the right fund is such that the focus is less on being in the relevant asset classes and more on listening to why stock no. 39 in the 5th largest equity fund exposure in the equity allocation of my portfolio is a potential multi-bagger.

4. Winners rotate – while I am still in the camp which believes that there will always be some strategies or investing approaches which can generate alpha over time, markets do rotate in and out of favour of styles, sectors and stocks. Even when one has identified the “right” funds or better still the “best” funds to invest in, there will be phases when the “right” fund doesn’t look just right and the “best” fund is going through its worst patch.

Winners rotate and it is observed that investors chase them. Even as investors make it a point to be in the “best” fund, usually they are there after it has become so; which results in them usually being behind the curve, as far as living the best vs. living with its prime having passed, is concerned. If you have identified the “right” or the “best” fund stick to it, if you are going to keep changing lanes you are better off with the index.

5. Simplicity of not having to make choices – it flows quite clearly from the above that not having to make choices is great. Barry Scwartz in his interesting book called “The Paradox of Choice” says that when people are giving a lot of choices, they tend to procrastinate in decision making, they make sub-optimal choices, they stray away from their original goals and most important, having made a choice and living some distance with it, the chances of looking back at the multiples forks in the road with regret and hence decisions coming unstuck is very high.

6. Ultimately everyone owns the index through a bouquet of diverse funds, so why not directly buy the index – anecdotal evidence and my experience of last two decades tells me that most investors own a plethora of equity products in their portfolios. If you buy the market you can’t beat the market. Nifty 500 is over 95% of our total market cap, BSE 200 is over 83-84% of our market cap.

So if you are someone who owns say 8 equity funds each owning about 40-50 stocks, even after de-duplicating the holdings you anyway own pretty much the entire market. Just the way an active fund manager needs to stick her neck out and take positions away from the index to beat the index, even you need to select few right funds if wish to beat the market for your equity allocation as a whole.

7. Costs – there is no doubt that lower costs can directly add to returns. Irrespective of performance someone looking to lower costs will do better buying passive products.

8. Regulation demarcating fee charging advisory vs. commission earning distribution – intermediaries who function as investment advisors looking to charge a fee from clients would like to create a pocket in the clients’ investing expenditure by reducing the cost of underlying products which leaves the client indifferent to costs of paying an advisory fees. Fee based advisory is a tailwind for passive especially for low cost products.

9. Increasing awareness and education amongst investors, especially influence of western experiences and literature – irrespective of how the experience here in India pans out there is a lot of literature and experiences emerging out of the USA which shows the prowess and penetration of passives and the reasons for the same in the USA. The USA is the mecca for the investing world and their influence on investment thinking is undeniable.

10. Performance of index –does institutionalization and efficiency of markets result in passivization or does passivization result in performance of index which in turn results in more passivization or does regulatory commoditization and straight jacketing of mutual funds result in passivization?

For instance, in India if large entities such as the EPFO with their money might are buying passives, which is surely a tailwind for passives and straight jacketing mutual funds’ investments regulatorily into narrow bands of market capitalization too is a tailwind for passivization.

Long story short, if you are someone who loves simplifying decision making and love to follow trends, passive funds should surely be on your consideration set in some measure and then you decide which way to tilt significant portfolio of your assets as experience plays out with time.