Retail investors and mutual funds: Here’s what gives highers returns than index funds

By: | Updated: June 24, 2016 7:18 AM

Most investors prefer active funds as fund managers can customise the investment mix depending on the investors’ goal and risk appetite

One of the biggest disadvantages of passive funds is that even if any included company is not giving good returns for a long period, the fund manager’s hands are tied as the company is part of the index. (Reuters)One of the biggest disadvantages of passive funds is that even if any included company is not giving good returns for a long period, the fund manager’s hands are tied as the company is part of the index. (Reuters)

For retail investors, mutual funds are one of the most convenient instruments to invest in both equity and debt. The fund manager invests the money in stocks after analysing the fundamentals of the company and the funds are segregated into two types – active and passive funds.

In active funds, which is the most popular one for higher long-term returns, the fund manager manages the fund by by selecting the sectors and companies to invest. He then decides on the proportion of equity and debt depending on the fundamentals of the company. The fund manager looks at various macro economic factors before deciding on the sectors to invest. In active funds, if the fund manager finds that the growth prospects of a sector or a company specifically has diminished, he will remove it from the fund and invest in the one which has higher potential for growth.

On the other hand, in passive funds, the fund manager always follow an index of the stock market and invests accordingly. and don’t require active management. Know as index fund, it tracks the components of a market index, such as the Nifty or the Sensex. Index funds provide broad market exposure, low operating expenses and low portfolio turnover and is meant for those who do not want to track and invest in individual securities and wish to invest in a benchmark.

The investment objective of index a fund is to get returns in line with the targeted benchmarked index. These funds carry the same risk associated with any other mutual fund and the movement in the indices will be reflected in fund’s NAV. For instance, an index fund that tracks the BSE Sensex comprising stocks of 30 blue-chip firms, will gain when the Sensex goes up and will lose when the benchmark falls. The biggest advantage of passive funds is the low expense ratio, which can be around 0.5-%.

However, the returns generated by index funds most often do not match the index returns because of the tracking error. The lower the tracking error, the closer will be the returns to the benchmark. Moreover, index funds always set aside a certain percentage in cash to ensure that in case of redemption from investors, there is sufficient liquidity.

One of the biggest disadvantages of passive funds is that even if any included company is not giving good returns for a long period, the fund manager’s hands are tied as the company is part of the index. The fund will have no option but to retain the company in its portfolio, which will affect the returns for investors.

Apart from tracking error, changes in index constituents and corporate action like declaration of dividend and bonus, will also make the fund realign to the indices. Actively managed large-cap funds, which typically invest in top-100 or top-200 companies, have outperformed the Sensex and the Nifty in the long run.

Most investors prefer active funds as fund managers can customise the investment mix depending on the investors goal and risk appetite. For instance, if the fund manager thinks that the RBI may cut interest rates for a few quarters, then the fund house would launch bond funds to take advantage of the drop in rates. However, active funds have have higher expense ratio of 1.5-2.5%, which may lower the net returns of the investor. Analysts say returns over the last two decades show that actively managed funds have given higher returns than index funds.

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