Safe way to invest

“Not necessarily,” I replied. “First,let us understand the difference between these two types of funds. An actively managed fund is one where the fund manager uses his expertise to select a portfolio of stocks. It is hoped that this will provide better returns than an index. Diversified equity funds fall under this category. Typically,the fund manager has a team of people who assist him in stock selection and calls that need to be taken. The costs of the fund manager and his team are borne by the investors in a mutual fund.”

What are passive or index funds?

“On the other hand,a passively managed fund is an equity mutual fund that invests in stocks that constitute a stock index,such as BSE Sensex or NSE Nifty. These funds are also known as index funds. The amount invested in these stocks is in the same proportion as stipulated by the index. As a result,index funds do not rely on the expertise of an individual fund manager. Returns generated from these funds are closely linked to those produced by the underlying index.

An index fund usually has a much lower management fee compared with that of an actively managed equity fund. A sub-class of index funds,exchange-traded funds (ETFs),carries even lower costs than index funds,” I added.

Yohan nodded. To Sonia it was a no-brainer that a fund managed by an expert is bound to do better than an index fund. However,I disagreed. “All actively managed funds cannot do better than the index. It is a mathematical impossibility,” I said. They both looked surprised.

All active funds cannot outperform index funds

“Before we begin,there are two things that we must understand. First,the returns of the stock market are measured by an index such as the Sensex or the Nifty. The terms market and index are often used interchangeably in this context.

Second,we must know what mathematical average means. Let’s say,a cyclist travels at 20 kmph for the first hour and at 10 kmph for the second hour. Therefore,the average speed of the cyclist over the two-hour duration is 15 kmph (Formula: (20+10)/2). This average implies that travelling at two different speeds is equivalent to travelling both the hours at 15 kmph.

On similar lines,let us assume that the average return from the market is 15 per cent during the last year. Two kinds of investors exist in the market: active and passive. Passive investors buy all the stocks in the market and hold them. They,therefore,get a return of 15

per cent.

Active investors,on the other hand,have varying returns based on the stocks they picked,when they bought them,and so on. As stated earlier,the average return from the entire market is 15 per cent and passive investors got 15 per cent return. Therefore,the entire set of active investors as a whole must also return 15 percent. This is based on the concept of mathematical average explained above.

To achieve this average of 15 per cent,some active investors will do better than the market and return,say,20 per cent. But a corresponding number will have to under-perform the market and give a return of only 10 per cent. This means that not all actively-managed funds can outperform the market in any given period. The law of averages mandates that there will be a number of actively-managed funds that will under-perform the index.

Further,actively-managed funds typically have greater expenses than that of index funds. So if a portfolio of actively-managed funds and an index fund fetch the same return,then investors of actively-managed funds will receive poorer returns,” I said.

Conclusion

Yohan and Sonia understood the concept. “Okay,but clearly some actively-managed funds are very likely to do better than index funds. So why not invest in those?,” asked Yohan.

“If one knows about such funds,one should definitely invest in them. The problem is that it is very difficult,if not impossible,to identify which funds will do better in the next five years. In hindsight,you always have a list of top-performing funds. But predicting the future is not as easy. Various studies have shown that a top-performing fund in a given five-year period may underperform the index over the next five years. That is why the warning ‘past performance is no indication of future returns’,” I said.

“So,it’s better to go with the consistency of an index fund rather than take a chance on actively-managed fund,” said Sonia.

“That is correct,” I said.

Yohan and Sonia thanked me and left.

The writer is a Mumbai-based certified financial planner and chief executive officer at Sardesai Finance.