ETFs narrowing the performance gap vis-a-vis active funds? The debate over whether to invest in active funds or ETFs is a long-standing one. An ETF or exchange-traded fund passively track an index such as the Nifty or Sensex. It buys stocks in the same proportion as the index and merely seeks to replicate index returns. In return for giving up on outperformance, an ETF will typically charge much lower fees than its actively managed counterpart. An active fund, on the other hand, will have a fund manager identify stocks and seek to outperform the index.

In India most ETFs track only two indices – Nifty and Sensex. Their active counterparts are hence mostly large-cap equity funds. In this article, we examine whether these funds have beaten ETFs and to what extent.

Why ETFs

The argument for ETFs springs from the ‘efficient markets hypothesis’ which postulates that all public information is instantly incorporated into the price of a stock, leaving little possibility for outperformance by professional investors. The world’s first ETF was launched in Canada in 1990. John Bogle of Vanguard Asset Management rapidly expanded this structure in the USA by launching Vanguard Index Funds. Vanguard is now one of the world’s largest asset managers.

A complete acceptance of the efficient markets hypothesis theory implies rejection of the all actively managed mutual funds. However, some investors prefer to accept ‘weaker versions’ of the theory, allowing for some inefficiencies and pockets of arbitrage to exist. This is particularly true in young, emerging markets where every stock isn’t as widely tracked and liquidity isn’t as large as say, the US market. These factors may have allowed actively managed funds to outperform in India.

What the data says

Data from Bangalore based Pulse Labs shows that over the past five years, a whopping 47 out of 57 large cap schemes have beaten the average returns of Nifty ETFs. This came to 82% of the total. However, this steadily declined to just 20% of all large-cap schemes over the past one year.

Category 1 Year 3 Years 5 Years
Total number of large-cap schemes 61 59 57
Number of outperformers v Nifty ETFs 12 34 47
The proportion of outperformers 20% 58% 82%

Data as on 11/05/2018, Source: Pulse Labs, Data for Regular Plans

Large-cap schemes on average delivered an impressive 16.52% CAGR over the past five years compared to 13.84% for index ETFs. This outperformance continues over the past three years but ends if you look at one-year returns. Nifty ETFs actually did better than actively managed large-cap funds over the past one year.

Average Returns (% CAGR) 1 Year 3 Years 5 Years
Nifty ETF 16.78 10.85 13.84
Large Cap Schemes 13.24 11.58 16.52

Data as on 11/05/2018, Source: Pulse Labs, Data for Regular Plans

Another way to look at this is through rolling returns because rolling returns take care of the ‘you have an arbitrary starting point’ argument. These returns look at different start-dates, moving ahead by one month at a time and correct for this possible ‘bias.’ Here is what they look like:

Returns (% CAGR) 1 year 3 years 5 years
Average ETF 14.06% 10.41% 13.84%
Active Large Cap 12.01% 11.65% 17.00%

Data as on 11/05/2018, Source: Pulse Labs, One-month rolling returns of 64 large cap schemes and 3 major ETFs observed; Data for Regular Plans

Once again, the same pattern is repeated. There is outperformance over a five year period but this declines over a three year period and reverses itself over a one year period with ETFs actually outperforming large-cap funds.

RupeeIQ Take

The trend of a narrowing gap in the outperformance of large-cap funds vis-a-vis ETF may mean the former have to significantly up their game to stay competitive. If it persists, mutual funds will find it harder and harder to justify their fees and expenses. However, one year is too short a time to conclude anything. We will have to wait for longer-term data for confirmation.

Also note, only averages are compared here. Exceptional funds will continue to outperform and generate much more wealth for investors than indices.

Author
Neil Borate

Neil Borate is Deputy Editor, RupeeIQ. He can be contacted at neil@rupeeiq.com.