Do active funds really outperform passive ones? The answer depends on category and costs

Active versus passive investing is a long-running debate among mutual fund investors. While active funds aim to beat their benchmarks through stock selection, passive funds seek to replicate an index at a relatively low cost.

But does paying for active management actually improve an investor’s chances of earning higher returns?

Apurv Gupta, Founder & CEO, Otto Money, answered this question by analysing monthly rolling three-, five-, and seven-year periods from January 2013, when direct plans were introduced. The analysis covered active direct-growth equity funds across seven categories and about 44,500 fund-window observations.

Each active fund was compared with its benchmark after deducting 0.20% a year from the benchmark return to account for the cost of investing in a real index fund.

The findings suggest there is no clear winner between active and passive investing. Gupta explains that the choice depends on the market segment, the fund selected, and the costs involved.

Where do passive funds have an edge?

Passive funds appear to work better where the stock universe is relatively narrow and companies are well researched.

In large-cap, mid-cap and large & mid-cap categories, active funds beat their benchmarks in only 30% to 52% of monthly rolling three-, five- and seven-year periods.

These segments have a smaller pool of widely followed stocks, with thousands of analysts tracking them. As information is quickly reflected in stock prices, consistently finding opportunities to beat the index becomes harder.

For investors, this makes index funds a strong option for the large- and mid-cap core of a portfolio.

When does active management
have a better chance?

The picture changes when the investment universe becomes broader and less researched.

Active funds outperformed in 57% to 65% of rolling periods in flexi-cap, focused, and value categories. However, the median advantage was less than 1% a year.

Small-cap funds were the clear standout. They beat their benchmark in 90% of the time over a 7-year horizon.

It means investors historically had a much higher probability of finding active funds that added value in this segment, where the stock universe is broader and research coverage can be less extensive.

Why does fund selection matter so much?

The overall success rate of a category can hide a much bigger difference between individual funds.

In seven-year periods, the flexi-cap fund at the 5th percentile underperformed its benchmark by 4.3%, while the 95th-percentile fund outperformed it by 5.8%.

That is roughly a 10-percentage-point gap, compared with a median active advantage of just 0.6% a year.

This means fund selection adds another layer of risk because the investor is betting on a particular fund manager to outperform the index. Hence, the fund you pick inside it sets your outcome.

Do regular plans reduce the benefit of active funds?

Yes. For flexi-cap funds, active funds beat the benchmark in 63% of seven-year windows for direct plans, compared with 47% for regular plans.

In large-cap funds, the figures were 30% for direct plans and 11% for regular plans, while in mid-cap funds, they were 46% and 28%, respectively.

The difference was also visible across other categories. For example, active funds beat their benchmarks in 90% of seven-year windows in small-cap direct plans, compared with 78% for regular plans.

This means commissions and other costs can consume much of the manager’s potential outperformance. Other than small-cap funds, an investor is better off with index funds compared to commission-laden plans.

What does this mean for investors?

• Use index funds for the large- and mid-cap core of the portfolio.
• Consider active funds where the stock universe is broader, particularly small-caps.
• Choose the fund carefully, because the difference between a good and a poor active fund can be much larger than the average advantage of active investing.
• Prefer direct plans for active funds, as commissions can cost more than the average manager adds.