The Balancing Game: Decoding the Case for Active vs. Passive Investing

Investing in active vs. passive funds has always been a topic of debate. However, after analyzing historical data, several key insights emerge:

• Active flexicap managers have generally demonstrated greater reliability in outperforming their benchmarks compared to their largecap peers. The flexibility of active management in adapting to changing market conditions has consistently helped flexicap funds generate positive alpha.
• Active largecap Funds have shown inconsistency in delivering excess return over their benchmarks.
• As a result, a balanced approach between the two categories might be optimal. Passive strategies could be used for largecap allocation, while active managers might be used for flexicap allocation.

1. Largecap Category

• We observed that the Nifty 50 Index Fund consistently ranked in the first and second quartiles (Q1 & Q2), indicating that only a few large-cap active fund managers outperformed the benchmark (HDFC Nifty 50 Index Fund).
• Out of 12 instances, the Nifty 50 Index has ranked in the first and second quartiles (Q1 & Q2) nine times. Recently, the Nifty 50 Index was in the fourth quartile (Q4) H1 2024 and only twice in third quartile (Q3) on a three-year trailing basis (HY2 2023 and HY2 2021).

Illustration 1: Active Largecap Funds 3-Year Trailing Returns

Our View:

• The performance of active largecap funds has been inconsistent. While they have outperformed in certain periods, maintaining this outperformance over the long term has proven difficult, especially in the largecap space. Many active funds struggle to consistently beat the market.
• Passive investing tends to be more effective in long-term, upward-trending markets, where cost is a significant factor, particularly in the largecap space, where the fund's goal is to closely track the benchmark performance.

2. Flexicap Category

• Active flexicap funds have historically behaved differently to the active largecap fund category.
• Out of 12 instances, the BSE 500 Index was in the third quartile (Q3) seven times on a three-year trailing basis, indicating that many flexicap active fund managers could outperform the benchmark (ICICI Prudential BSE 500 ETF).
• There have been five instances where the BSE 500 Index was ranked in the second quartile (Q2).

Illustration 2: Active Flexicap Funds 3-Year Rolling Returns

Illustration 3: % of Active Funds that have Outperformed the Benchmark

Illustration 4: Number of Times Active Fund Have Outperformed the Benchmark

Largecap Fund:

• The percentage of active largecap funds outperforming the benchmark has shown significant fluctuations over the observed periods.
• The highest outperformance was seen in June 2024 (75%), while the lowest outperformance occurred in December 2020, with only 11% of funds managed to outperform the benchmark. (Illustration 3)
• Recent trends indicate a recovery, with the outperformance rising to 75% in June 2024 after a low of 31% in June 2023. (Illustration 3)

Flexicap Fund:

• Active flexicap funds generally showed more consistent outperformance compared to largecap funds.
• The highest outperformance was 73% in June 2024, indicating a positive recent trend. (Illustration 3)
• The lowest outperformance was observed in December 2020 (30%), but there has been a steady improvement since, with the most recent figures showing 73% in June 2024. (Illustration 3)
• Overall, active flexicap funds have been more resilient, with most periods showing over 50% of funds outperforming their benchmarks. (Illustration 4)

Our View:

• Active flexicap funds have generally been more consistent in outperforming their benchmarks, whereas active largecap funds have struggled with consistent alpha generation.
• For instance, since December 2020, over 50% of active flexicap funds have consistently delivered alpha over their benchmark (BSE 500 TRI).
• In contrast, active largecap funds have experienced uneven performance in delivering alpha over their benchmarks. Although there has been a recent recovery with noticeable improvement, the long-term trend has remained inconsistent.
• Active management has proven advantageous for Flexicap Funds, where fund managers have successfully navigated across various market caps. The flexibility to adjust portfolios and adapt to changing markets has consistently helped generate alpha.
• Thus, it is important to engage in a ‘Balancing Game’ between largecap and flexicap categories. Considering the inconsistent performance of active largecap funds, we believe a passive strategy is better suited for largecap asset allocation. On the other hand, the flexicap category is most effectively managed through active strategies.

Mutual fund investments are subject to market risks, read all scheme related documents carefully. For important details, please read our disclaimer.

Market Risk: Investments are subject to the standard risks associated with equity markets.

Concentration Risk: Certain funds may be concentrated consisting of a few stock ideas; may have higher volatility as well as higher drawdowns as compared to others.

Market Timing Risk: The timing of point of entry and exit in the strategy may be different in case of certain funds which may result in difference in performance of the funds.

Market Capitalization Risk: Certain funds may invest in securities of companies with small-to medium-sized market capitalizations which involve higher risks in some respects than investments in securities of larger companies.