Which is Better – Index Funds VS Actively Managed Funds | History, Advantages, Performance and Risk

For many weeks now we have been talking to dozens of et money investors about their investment habits, the strategies they use and also the opinions they have. One of the questions we have always asked ourselves is: do you invest in

index

funds

? Hello everyone, my name is. shankarnath and this video is made specifically for people who don't understand passive investing or who are skeptical about

index

funds

and their ability to compete with

actively

managed

mutual funds, so whether you are ignorant or skeptical, there is something for everyone In this video, as we also delve into this active versus passive investing debate with some

history

, some data, some analysis, and a little opinion to

better

understand index funds, we have to go back almost 100 years to another financial innovation.

which

really introduced financial markets into the lives of For common people like you and me, the modern mutual fund industry began in the year 1924.

Since then, mutual funds have served millions and millions of people who have little time and knowledge to buy individual stocks but can now rely on the services of a professional fund manager. Who would research the vast universe of companies and execute the most suitable trades for a small fee? Interestingly, investor expectations at the beginning of the 20th century were not so much about

performance

as about the desirability of mutual funds also offering stock market indices and benchmarks such as the Dow Jones Industrial Average or the SP 500. They were at a very early stage of development and were used mainly in academic studies.

Now, this undemanding relationship between investors and mutual funds went on for a few decades and largely continued in the 1950s and especially in the 1960s, when interest in mutual funds really increased and with this emerged many professors and academics who became more interested in understanding how available data on fund

performance

could be used to select funds and fund managers that could outperform in the future. critical moment in the development of index funds because when academics began looking at fund performance data they realized that most mutual fund managers had underperformed the markets for many years and decades , this became a kind of catalyst for change and after some failures. begins the first publicly available index fund was launched by the vanguard group in 1976.

So if we look back at this story that I just shared, it is not that index funds first appeared and after a few years they started to perform higher than

actively

managed

. mutual funds, on the other hand, index funds had already started on a solid basis, so it was a matter of raising awareness among investors about the virtues of passive investing but, more importantly, from the perspective of the investment community, the Introduction of index funds was a turning point, as not only index funds did it. give investors a choice, they also forced active fund management companies to redefine their entire purpose, meaning that for the first time fund management companies realized that it was not enough to simply offer a basket of securities to investors, but these fund managers now had to beat the market.

That is, they had to outperform the benchmark,

which

was no longer a tape measure, but something investors could now invest in. This is, in fact, the genesis of index funds and is important because, on the one hand, there is the core belief that you need to apply some intelligence to make money in the stock markets, which is what managed mutual funds do. They actively want you to believe, and then there are index funds that challenge the same notion by questioning why most fund managers can't beat even something as simple as an index, so that's a little

history

and Now let's understand a little more about index funds in the field of investment, an index represents the value of a particular group of investments, for example, the sensex is an index that tracks the performance of 30 of the largest and the stocks that They are most actively traded on the Bombay Stock Exchange;

Similarly, the Nifty 50 index represents the weighted average of 50 such companies in the national stock exchange, in a nutshell, an index is nothing but a generic term that describes a list of securities that are selected and weighted accordingly. With a set of rules and because it is nothing more than a set of rules, you can create an index for almost anything, for example, on the website nifty indices dot com you can find over a hundred different types of indexes. Yes, the common exists. nifty 50 the nifty next 50 the nifty mid cap 150 but there are also a number of other indices like the nifty mid cap liquid 15 the nifty 50 value 20 index the nifty tata group index which specifically features the tata group companies and so on in De In fact, very recently we uploaded a video on one such index strategy called nifty 200 impulse 30 index where we discussed details on how an index is constructed.

It's a very interesting video, so check it out and if you haven't already, subscribe. Go to etmoney YouTube channel and tap the notification bell icon to receive timely video alerts. Now an index fund is simply a fund that tracks a market index; In other words, the index fund simply buys all the stocks that make up a particular index for weightings. and the prescribed methodology, for example, the dsp nifty 50 index replicates the structure of the nifty 50 index and you end up buying and holding the 50 stocks that are part of the nifty 50 index, which means that if the nifty 50 index goes up by 2 today the dsp The nifty 50 index fund will also increase by 2.

Now remember that a fund has some expenses, so the returns delivered by the index fund will be slightly lower than the index itself, which in other words means that the index fund owns all the actions that compose it. In the market, one would end up getting the average returns of all the stocks in that market. This, of course, begs the question of why anyone would be happy with only average performance. It's a pretty valid question and something we'll discuss in more detail later in this article. video, but on the plus side, index funds offer some unique

advantages

, as index funds offer much broader diversification than an actively managed mutual fund can offer, but probably the biggest visible advantage of index funds has to do with its unique ability to keep fund management expenses to a minimum, the index fund achieves this by not having to pay advisory fees or salary to a research team and b by saving due to low portfolio turnover, which reduces business rates and taxes, in fact, to put this into practice. numbers, the average expense ratio of a direct plan of a typical actively managed large cap fund is 0.95 per cent, compared to this, the expense ratio of direct plan of a typical large cap index fund like nifty 50 next 50 or nifty 100 is about 0.24, so we can clearly see a seven percent difference in expenses, which I must say is quite a large number and the impact of this seven percent point would become clear to As we move forward in this video, in addition to diversification and low expense index funds serve as one of the best vehicles that support asset allocation in a previous video we had shown how asset allocation can be done and how it serves as the backbone of a good investment plan.

Now we won't cover asset allocation in this video, but we definitely will. We will detail this process very soon in a follow-up video on how to build a passive investing plan. Since index funds were introduced in the 1970s, there has been a battle between actively managed funds and passively managed index funds. In this section we will examine this fight from three perspectives: one, the moral justification, two, the performance angle and finally, the explanation of

risk

from a moral perspective. Actively managed funds believe that markets are often mispriced and the fund manager is in the best position to exploit this opportunity and make a decision. a lot of money for the investor, on the other hand, the opinion of the index administrator is that the current price at which any stock is trading has already taken into account all known and available information;

In other words, this is the price agreed upon by a willing buyer and willing seller on the open market and therefore it is impossible to capture excess returns without taking on additional

risk

s, so these are the moral perspectives of the active side and the passive side, who is right and who is wrong will probably remain unanswered for maybe another 100 years, so we don't really want to get into this now, but with that being said, let's move on to the performance angle. Now there is already a lot of data available pertaining to the s p 500 and other US based indices, so for this video.

We started analyzing some data from India to help us shape our opinion more specifically. We looked at all available actively managed large-cap funds and all available large-cap index funds for comparison. It turned out to be a pretty decent universe of 44 large caps. cap funds, so there were 29 actively managed funds and 13 large cap index funds and this is how the annual returns of the average index fund compare to the average actively managed mutual fund in the most recent years, especially from 2018 onwards , we see that index funds have performed a little

better

than the average mutual fund; In fact, we see a considerable amount of point one percent, two percent, three percent across the data, which shows that in any normal year there is not much difference in performance between an average actively managed mutual fund and a index fund, now let's dig into the data and understand how many of these active funds have underperformed compared to the typical nifty 50 index funds.

If we give more weight to recent years, from 2018 onwards, we see that half or Just over 50 percent of actively managed large-cap funds have struggled to keep up with a nifty 50 index fund. In fact, our research shows that in 2018 only two actively managed funds outperformed index funds and all the other 26 funds underperformed. The ratio in this data table is actually very important because if we average the data over the last four years we see that 61 of the active funds have underperformed now. The reason I mention this is because global data on active versus passive funds shows that they win and lose.

The ratio is about one to two, i.e. around 66 per cent of actively managed funds actually underperform index funds in India. This ratio appears to be more of one to one if we take the last three years of data, but it is very close to the ratio of one to two if we take the last four years of data, so this is definitely something that investors long term as we should look at and consider in our future portfolio decisions. Okay, now this is what our skeptical investor might say. Well, you could say. I have special powers and I can select a fund that outperforms every time, very good for you, but if you remember, there was a video we had made about the follies of chasing high-performing mutual funds where we showed with data that a large number of funds After occupying position one, two or three in the previous years they have performed extremely poorly in the immediate next year, but this is where we must examine the third and final perspective, which is the risk angle now that most of the Consumers do not buy units in just one mutual fund but over time they have a portfolio of mutual funds in that context the risk we will talk about is selection risk as in our case there are 29 actively managed mutual funds and let's say the An investor chooses two funds, the danger here is that it is very possible that one fund will underperform the index while the other will outperform;

That's the trade-off at play here, meaning the outperforming active fund will need to offset losses suffered by the underperforming one. said, let's look at the data again, the second column here shows theAverage alpha or excess returns created by all mutual funds that have outperformed the average index fund. For example, in 2019, the 14 active funds that outperformed index funds earned excess returns of 2.4 percent. percent on the returns of the index fund. Similarly, the third column shows the level of poor performance of the active underperforming funds, so for the year 2019 the 15 underperforming funds averaged a negative return of 1.8 percent now if averaged weighted plus 2.4 with negative 1.8 percent, we found that our portfolio would end up with a positive number, meaning that selection risk is mostly non-existent unless you choose two underperforming funds, which which hopefully shouldn't happen anymore with the one-to-one ratio we see in most years except 2013 and 2018, we don't face as much selection risk, but the problem is that a one-to-one ratio is an aggressive ratio because our data shows that India two is moving towards a one to two ratio of assets and liabilities. fund performance, so when we weight one is two, our data and especially over the last four years is starting to show a higher level of selection risk, so from a risk perspective the message here is that if you don't drags, investing in actively managed funds can generate high uncompensated risk in a portfolio, which is something we really don't want.

This battle between index and actively managed funds has already been 50 years in the making, and if the data were to be believed, index funds appear to be winning globally. Index funds have captured greater participation. wallet share compared to active funds and there is a growing case for this to happen in India over the next decade and if some of you are wondering why you haven't switched to an index fund sooner, the only plausible explanation that We find this to be with our cultural belief that success in investing is a function of a person's ability to successfully choose winning stocks;

In other words, we need to do some kind of mental work to earn money; It is something that has been ingrained in us through our education, our upbringing, and the media. exposure we have received over the years, but we really hope that this video has shown that this does not have to be the case and that a model or strategy is capable enough of delivering adequate and excellent returns on your capital, in fact If you like this video, please visit our channel again next week when we publish another video on index funds where we detail some specific strategies and steps one can take to improve the returns of their index funds while taking on less risk and with this we come to the end . of this video help us spread the good word by sharing this video via WhatsApp, Facebook and Twitter with your friends and connections and if you have any questions for us please post them in the comment box below, thank you for your time and we look forward to seeing you.

We'll catch up with you next week with another revealing video. Until then, investments in mutual funds are subject to market risks. Carefully read all documents related to the plan.