Active equity vs passive equity investing in India
The active-versus-passive debate in Indian equity investing examines whether actively managed equity mutual funds, where a fund manager selects stocks based on research and conviction, consistently deliver higher risk-adjusted returns than passively managed funds that simply replicate a market index at lower cost.
This article presents the empirical evidence, cost analysis, and structural arguments advanced for each approach in the Indian market context as of 2024.
Definitions
Active equity fund: A fund where a fund manager and research team construct a portfolio of stocks based on fundamental analysis, valuation, sector views, and risk assessments. The fund’s benchmark (e.g., Nifty 50 TRI, Nifty 500 TRI) serves as the reference; the manager aims to generate alpha (return above the benchmark). Cost is higher due to research staff, portfolio management fees, and higher transaction turnover.
Passive equity fund: An index fund or exchange-traded fund (ETF) that holds the constituents of a specified index (e.g., Nifty 50, Nifty Midcap 150) in their index weights. No active stock selection occurs. The fund’s return tracks the index minus TER minus tracking error. Cost is minimal.
Cost differential
| Fund type | Typical TER (direct plan) |
|---|---|
| Active large-cap fund | 0.5%–1.0% |
| Active mid-cap fund | 0.6%–1.1% |
| Active small-cap fund | 0.6%–1.2% |
| Active flexi-cap fund | 0.5%–1.0% |
| Nifty 50 index fund | 0.05%–0.20% |
| Nifty Midcap 150 index fund | 0.15%–0.40% |
| Nifty Smallcap 250 index fund | 0.20%–0.50% |
The cost advantage of passive funds is structural and perpetual. Active funds must generate alpha at least equal to the TER differential just to match the index fund’s net return.
SPIVA India scorecard
S&P Dow Jones Indices publishes the SPIVA (S&P Indices Versus Active Funds) India Scorecard periodically. The SPIVA methodology compares the percentage of actively managed funds in each SEBI category that underperform their designated benchmark index over one-year, three-year, five-year, and ten-year periods.
SPIVA India Year-End 2023 findings:
| Category | % underperforming over 5 years | % underperforming over 10 years |
|---|---|---|
| Indian Equity Large-Cap | ~73%–78% | ~80%–85% |
| Indian ELSS | ~66%–72% | ~73%–80% |
| Indian Equity Mid-/Small-Cap | ~52%–60% | ~65%–70% |
The data consistently shows that over long periods, the majority of active funds in the large-cap category underperform their benchmarks. Performance in mid-cap and small-cap categories shows a higher proportion of active outperformers than large-cap, though the percentage underperforming still exceeds 50% over longer horizons.
SEBI’s categorisation changes (2017) and subsequent scheme rationalisation have narrowed the benchmark-beating capacity of large-cap funds specifically, as the restricted universe (top 100 stocks, of which Nifty 50 represents 50) limits differentiation.
Arguments for active management in India
Several structural arguments are made for the potential of active management in India:
Market inefficiency: Indian equity markets, particularly mid-cap and small-cap segments, have lower institutional ownership, lower analyst coverage, and less efficient price discovery than US or European large-cap markets. This creates potential for informed stock selection to generate alpha.
Mid- and small-cap alpha: SPIVA data and independent research show a higher proportion of active mid-cap and small-cap funds outperforming their benchmarks relative to large-cap funds. This is consistent with the market efficiency argument: the Nifty Midcap 150 and Nifty Smallcap 250 are less efficiently priced than the Nifty 50.
Cyclical opportunities: India’s economic cycle creates periods of sectoral mispricing that active managers can exploit through overweighting/underweighting sectors.
Index reconstitution effect: Passive index funds must buy stocks added to the index and sell stocks removed at the reconstitution dates, potentially buying at elevated prices from index-aware sellers. Active managers can pre-position.
Arguments for passive management in India
Cost certainty: The TER differential (0.4%–1.0% per annum) is certain and permanent. Generating consistent alpha to overcome this hurdle is demonstrated to be rare even for top-quartile funds.
Survivorship bias: Fund performance data overstates historical active returns because poorly performing funds are merged or closed; only surviving funds appear in long-term return comparisons. SPIVA adjusts for survivorship bias in its analysis.
Manager continuity risk: Active fund alpha is often attributed to a specific fund manager. Manager departures transfer the fund to a different style, potentially losing the source of historical alpha.
Tax efficiency: Lower turnover in passive funds implies fewer realised capital gains within the portfolio, potentially improving pre-TER tax efficiency at the portfolio level.
Simplicity: Index funds require no ongoing fund manager evaluation or switching decisions.
EPFO and passive investing
The Employees’ Provident Fund Organisation (EPFO) began mandating passive equity ETF investments from 2015 (EPFO circular), deploying a portion of its corpus into Nifty 50 and Sensex ETFs. By 2023-24, EPFO had deployed over Rs 2 lakh crore into ETFs, making it the largest single institutional participant in Indian equity ETFs. This has increased ETF AUM and liquidity significantly.
Summary comparison table
| Dimension | Active equity fund | Passive index fund/ETF |
|---|---|---|
| Stock selection | Fund manager driven | Rules-based; index replication |
| TER (direct plan) | 0.5%–1.2% | 0.05%–0.50% |
| Alpha potential | Yes; but majority underperform over 5-10 years (SPIVA) | Tracks index minus TER |
| Manager risk | Yes | Not applicable |
| Best suited category | Mid/small-cap (higher alpha record) | Large-cap (lower active outperformance) |
| Cost certainty | Uncertain (TER varies; may be revised) | Certain; TER is near-floor |
| Complexity | Requires fund evaluation | Minimal; choose index |
| Tax efficiency | Lower (higher portfolio turnover) | Higher (lower turnover) |
See also
- Large-cap fund vs index fund
- Index fund vs ETF in India
- Mutual fund vs ETF in India
- Multi-cap vs flexi-cap
- Nifty 50
- Mutual fund
- How to invest in index funds on Coin
- Zerodha ETF
References
- SPIVA India Scorecard Year-End 2023, S&P Dow Jones Indices.
- SEBI circular SEBI/HO/IMD/DF3/CIR/P/2017/114, Categorisation and rationalisation.
- AMFI, Fund performance and AUM data.
- EPFO, Equity investment guidelines (CBT resolution, 2015).
- NSE, Nifty 50 index methodology.
- SEBI (Mutual Funds) Regulations, 1996.