Active vs index fund - when markets take sharp turns

Understand the dynamism of active funds in volatile situations.

Striking a balance is key in the world of investing. For years, investors have grappled with the question of how to best allocate their funds in the ever-changing stock market landscape. And the debate between active and passive funds remains a critical consideration for investors in this case. However, recent market events suggest how active funds have more advantages over index funds, especially with their ability to respond swiftly to unforeseen crises, potentially saving investors from significant losses.

The Adani-Hindenburg issue that unfolded in early 2023 serves as a stark reminder of how quickly market sentiment can shift. In the wake of this event, both the Nifty 50 and Nifty Next 50 indices experienced substantial declines, shedding 2 per cent and 8 per cent respectively. This downturn highlighted a key vulnerability of index funds, which are designed to mirror the performance of their benchmark indices, regardless of individual stock performance. For example, index funds tracking these benchmarks had no choice but to ride out the storm. However, some active fund managers were able to swiftly exit their positions in Adani Group stocks.

Keeping the market volatility in mind, should an investor choose an active fund or an index fund?

Now, it’s important to acknowledge that the choice between active and index funds isn’t a one-size-fits-all decision. An investor’s circumstances, risk appetite, and financial goals all play crucial roles in determining the right approach. 

Index funds, while offering low-cost market exposure, are restrictive. They must hold stocks in proportion to their weight in the index, irrespective of changing fundamentals or market dynamics. This rigid structure can leave investors scrambling, especially when high-weight components of an index face sudden crises.

Active funds, in contrast, have the flexibility to adapt to rapidly changing market conditions. For instance, during the Adani Group crisis, while index funds were compelled to maintain their holdings, active managers could make real-time decisions, reducing exposure to affected stocks and reallocating to more promising opportunities.

While index funds cannot hold cash, active funds can hold cash to take advantage of any market inefficiencies or opportunities. This cash also provides some protection to the portfolio of the active funds in times of volatility and safeguards the returns.

Moreover, active funds have the advantage of capitalising on market inefficiencies. The Indian market, with its wide range of over 5,000 listed companies, presents multiple opportunities for fund managers to identify undervalued stocks. For example, in the mid and small-cap segments, active managers can leverage their research capabilities to uncover hidden gems.

Although, it’s worth noting that active management isn’t without its own set of challenges. The S&P Indices Versus Active Funds (SPIVA) India Year-End 2023 report revealed that 74 per cent of actively managed mid and small-cap funds underperformed their benchmarks. However, this statistic also implies that 26 per cent of funds did outperform, highlighting the potential for skilled managers to add value.

Furthermore, active funds have shown their mettle in managing downside risk. During the market correction in March 2020, when the Nifty 50 fell by about 13 per cent, several top-performing active large-cap funds were able to limit their losses, showcasing their ability to provide some cushion during market downturns.

You see, the Indian market presents unique challenges and opportunities that can favour active management. Let us work with another example for context: The recent case of Brightcom Group Ltd. As news of its impending delisting broke, index funds holding its shares found themselves in a bind, unable to divest due to their passive mandate. Active fund managers, however, had the discretion to limit exposure or exit the position entirely.

Our economy can be characterised by rapidly evolving sectors, frequent policy shifts, and a diverse array of companies at various stages of growth and governance. Navigating this landscape will require more than just tracking an index; it demands insight, analysis, and the ability to make timely decisions.

Active fund managers have several tools at their disposal to manage risk and potentially enhance returns:

Selective stock picking: Managers can avoid or underweight stocks they believe are overvalued or facing significant risks.

Sector allocation: They can adjust exposure to different sectors based on economic outlook and market trends.

Cash management: During periods of high volatility, managers can increase cash holdings to provide a buffer against market declines.

Opportunistic buying: When quality stocks are oversold, active managers can swiftly deploy capital to capture potential upside.

The bottom line is that while passive investing through index funds offers simplicity and low costs, the dynamic nature of active funds can provide an important layer of protection against market shocks.

(The writer is Founder, Director of Valtrust, a mutual fund distribution firm)