While markets have been in correction mode in recent times, the outperformance of equity markets since March 2020, as such, has swung the spotlight on the relative underperformance of active funds even as the buzz around passive funds grows louder.

It would, however, be myopic to countenance a long-term view in favour of either category based on this alone.

Indeed, there are multiple layers to the underperformance of active funds, shows a Crisil analysis.

A reality, but there is more to it

Among actively managed equity funds, it is the large-cap funds category that has fallen behind the most, especially since 2018 when re-categorisation of schemes was effected.

The re-categorisation has limited the investments of large-cap funds in lower-capitalisation stocks to less than 20 per cent of the portfolio. Skewed positive performance of some major companies and the inability of the large-cap funds to replicate the index weights of such companies due to exposure limits could also be impacting their performance.

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Mid-cap funds, too, have seen a dip in alpha in recent times.

Small-cap funds, however, continue to generate alpha versus their benchmarks. The large number of securities available in the small-cap space also provides a wide array of investment options, thus benefiting fund management in the space.

To be sure, the performance of active funds is also impacted by a number of other factors — holding period and scheme selection, among others.

As the investment horizon increases, the level of underperformance decreases, which indicates that equity investments are optimised only in the long term. Thus, investors might still be able to beat the market in their respective fund category if they hold on to their mutual funds over the long term.

Similarly, prudent scheme selection can impact portfolio performance. Dispersion of alpha shows that there is stark divergence between the best and worst funds in all categories.

Thus, an investor who does not choose the right fund, or monitor the funds invested in regularly, might end up with deficient alpha.

A combination can work

Individual participation in equity-oriented mutual funds continues to be focussed on actively managed funds. This is evident from the folio count of over 7.5 crore in the category, compared with just about 16 lakh in passive funds (AMFI data as of September 2021).

Given the right investment horizon and prudent scheme selection, active funds can certainly deliver the desired returns.

Lately, however, passive funds have grown exponentially in India. The spurt has been led by adoption of passive investing by large institutional investors such as provident fund trusts.

The potential for passive funds is also huge, considering the under-penetrated market and associated low costs. Asset manufacturers limited by regulation to launch products in the active space are expected to launch products in the passive space to shore up assets.

However, for mutual fund penetration to increase, hand-holding will have to play a major role.

Yet, the low-cost structure of passives might not incentivise intermediaries to take the product inland.

From an industry point of view, therefore, both these categories are equally important.

As for investors, a well-rounded portfolio with a mix of active and passive funds, based on the investor’s goal orientation, risk profile and preference, is the path to take.

The writer is Director, Funds Research, Crisil