Active vs. Passive Investing

Everytime there is a bull run in the market, it revives the debate around Active vs. Passive investing. This is because Index funds are most popular at the peak of a bull run. The biggest distraction area for mutual fund investors in bull markets is their inability to choose how they invest. They constantly switch sides between Active vs. Passive investing based on what does better over a 2-3 year period.

Just to be clear, in Active Investing – you (or the fund manager) try to select the most promising investment ideas based on your selection criteria. In passive investing, you simply buy an index like the Nifty 50, Nifty Midcap 100, Nifty Smallcap 100 etc. Your returns in this case will be in line with the performance of the underlying index. Here’s my short take on this whole debate –

1. Passive funds become popular when markets run up a lot. This is when investors look at index performance and get interested in passive investing.

2. When markets are recovering post a crash or when they are subdued, it is better to invest in active funds.

3. Stick to either one style. The most silly thing to do would be to keep switching between active and passive funds in different market cycles. If you are really not sure, invest your money equally in active and passive funds. It will help you stay the course.

4. 10 Year rolling CAGR of the Sensex / Nifty is between 9.5%-12.5%. If you are happy with this return, Choose passive investing.

5. If you want to buy 3 funds – large, mid and small. I would suggest buying an index for largecaps, and actively managed fund for mid and small caps.

I will focus on the fifth point highlighted above. If you look at the data presented below, you will notice that over the past 10 years, THE CHURN RATIO OF NIFTY 50 INDEX IS 32% (i.e. number of stocks that were changed over a 10 year period, in this case 16 out of 50). This is not bad. In my view a churn ratio of between 20-40% is ideal for a long term portfolio (held for over 10 years).

Nifty 50 Index - historical changes

During the 10 year period, Nifty 50 grew at a CAGR of 15.89%. If I compare this with the performance of some of the top performing largecap mutual funds, this is on average better (even if only just). I looked at 25 top performing pure largecap funds. Here’s what they delivered in the same period.

Mind you these are the top performing funds in this category and only 9 out of the 25 funds outperformed the index. It makes sense to cut the chase and just pick the Nifty 50 index fund for your largecap investing. Chances are that you will perform in line with the best performing largecap mutual funds with a deviation of at most 1% on either side.

Top performing large cap funds

Small and Midcap Index Stocks: where active investing has an edge

A related trend I have noticed over the years is that investors look to buy the most beaten down stocks (i.e. stocks which fall the most in a correction). This becomes their first filtering criteria. Basically, they are then looking to find value in the most beaten down stocks in the hope that they will recover at least half if not more in terms of price appreciation. Perhaps something which has fallen by 30-40-or 60% looks more attractive than a stock which has not fallen in line with the market.

In reality your thinking process should be exactly the opposite. Stocks which do not fall in line with market are far more likely to outperform compared to stocks which fall more than the market. All emperical evidence clearly highlights this. Yet, investors make the same mistake every single time – looking for beaten down stocks. 

There is a reason why certain stocks fall more than others whenever there is a slowdown or a liquidity crunch. Their valuations catch up with reality. When markets are bullish, quality stocks are the first ones to run up. Smart investors pay for stocks where their is visibility of earnings. Then comes a phase where optimists and risk takers jump in. In the last stage, speculators and storytellers join. Hence you will always notice that the stocks which run up viciously, fall even more viciously when the tide turns.

Coming back to the main topic – if you look at the performance of the Nifty midcap 100 index for the past 10 years, Nifty Midcap 100 grew at a CAGR of 18.68%. If I compare this with the performance of some of the top performing Midcap mutual funds, this has underperformed every single fund. THE CHURN RATIO OF NIFTY 100 INDEX IS 68%!!! (i.e. number of stocks that were changed over a 10 year period, in this case is 68 out of 100). To my mind, 68% churn is not really as passive a astyle of investing as a passive investor would like. Below this table of Nifty Midcap 100 stocks that were churned, you will also find a performance chart of the top 20 midcap funds.

Nifty Midcap 100 Index - historical changes

As I said above, the Nifty Midcap 100 index has compounded at an annual growth rate of 18.68% for the 10 year period between April 2014 – April 2024. This where active investing makes a lot more sense. Look at the past 10 year performance of 20 top performing midcap funds. Interestingly all these funds have beaten the Nifty Midcap 100 Index. 

Top performing midcap funds


Finally, lets come to the small cap index which for some reason is a favorite amongst young and restless investors. As a side note, personally I prefer midcaps over small caps for long term investing. I do buy specific small caps if I see a compelling case but I have a clear bias towards midcaps.

Consider this – Rs. 1 lakh invested in April 2008 (before a 60% crash in Nifty), would have become: Rs. 4.5 lakhs in largecaps Rs. 5.10 lakhs in small caps and Rs. 7.07 lakhs in mid caps. Based on index values as of date.

Believe it or not, out of the 100 stocks which constitute the Nifty Smallcap 100 index today, only 13 have remained in this index since 2014. 87 Stocks have been replaced in the past 10 years. I guess this is fair given how quickly small cap companies get destroyed and in some cases how they become big enough to not qualify for a place in this index.

Nifty Smallcap 100 index - historical changes

When it comes to choosing between Active vs. Passive investing, Smallcap category presents the most compelling case for investing in actively managed funds. Nifty Smallcap 100 Index has grown at a CAGR of 15.20% the past 10 years, underperforming its midcap peer. If you look at the top performing mutual funds in this category, they have all beaten this index by a mile.

Note: Only 10 small cap funds have a history with a track record of over 10 years, and all 10 have beaten this index.

Top performing smallcap funds

About Author