Why Active Investing is Still Relevant in the Second Wave of COVID-19

It is noteworthy that valuations of the equity market are expensive, running ahead of the fundamentals, and therefore the margin of safety has narrowed. Amid the second wave of COVID-19, the volatility is expected to intensify which makes being cautious about your investments crucial.

As you may be aware over the past few years, a significant number of actively managed funds, especially those that have a predominant large-cap biased portfolio have been unable to outperform the respective benchmark indices. As a result, many investors redeemed their investment in equity funds and dabbled directly in stocks. In view of this, many Mutual fund houses launched a slew of passively managed funds, a low-cost alternative, to attract investors.

But in my opinion, actively managed funds are still relevant and can outperform passive funds over the long term if you choose schemes carefully.

Why actively managed funds have underperformed in the last few years

• Most actively managed funds are overweight on stocks in the Banking and Financial sector. But amid the challenging economic situation, defensive sectors such as Pharma and Infotech outpaced many other sectors. Since most mutual funds were underweight on these sectors until a year ago, they could not fully cash in on this shift in sectoral rotation.

• The equity markets were polarised over the last few years where only a few top names in each market capitalisation witnessed significant growth. However, since actively managed funds restrict the maximum allocation in any individual stock to avoid concentration risk, the fund's returns were lower than the index returns. Passive funds do not have such restrictions because they simply mirror the composition of the index.

Besides, most diversified equity funds follow a buy-and-hold strategy to derive the long term potential of stocks they have invested in, benefit from compounding, and reduce volatility of the portfolio. They only churn a small portion of the assets to capitalise on the dynamic market conditions. As a result, active funds may underperform in the short term if the current trend is not in favour of the investment style/strategies adopted by the fund.

Here's why the active investment strategy is still relevant

Active funds aim to beat the market returns by taking tactical calls in stocks/sector/market caps, depending on the prevailing situations and future expectations. Whereas Passive funds aim to generate returns consistent with the underlying index.

Passive fund makes sense if you are a novice investor or a conservative one because you can select funds by simply comparing the expense ratio and tracking error of the fund. But if you want to invest in funds that have the potential to beat market returns over the long term, active funds could be your ticket!

While the underperformance of actively managed funds has been a cause of concern for investors, it is not the end of the road for the strategy. Often underperformance in the short term can weigh on the medium-term performance of the schemes. However, the long term performance record of many schemes across categories is encouraging where they have managed to outpace the indices and generate significant wealth for investors.

Historically, market volatility provided fund managers the opportunity to pick quality stocks at attractive valuations to reward investors over the long term. So by carefully selecting funds across categories and maintaining a diversified portfolio, you can achieve meaningful return over a long term horizon of 5 years or more.

India being an emerging economy means that various stocks across market capitalisation range have much scope of outperformance over the long term. Going forward, as the economy recovers, the market could witness a sustainable broad-based rally and actively managed funds could, therefore, generate superior returns. Thus, actively managed funds (including Large-cap funds) can still give the fund managers the opportunity to generate high alpha for its investors.

The table above shows the highest return clocked by any fund in a category during that particular period. While active funds may underperform in the short run, they can suitably reward investors who choose to stay invested for a longer period. Even the Large-cap funds category that has the highest underperformance rate in the 1-year period has remarkably outperformed the Nifty index funds over the long term horizon of 5 years or more.

While past performance is not an indicator of future returns, it shows the alpha-generating potential of actively managed funds. But remember that selecting a not so worthy active funds can cost you dearly.

Here is how you can maximise returns from actively managed funds amid the second wave of COVID:

1. Diversify across sub-categories and investment style - Diversifying investment in various sub-categories such as Large-cap Fund, Multi-cap Fund/Flexi-cap Fund, Mid-cap Fund, etc. can help you to lower the impact of volatility on your portfolio and thereby earn better risk-adjusted returns. It would also prove beneficial to diversify across investment style by investing in a worthy Value Fund.

2. Choose a worthy scheme based on quantitative and qualitative parameters - While returns are an important parameter to select a fund, one should look at other aspects to invest in a fund that can perform consistently well across market phases and cycles. It is important that while generating higher returns, the fund keeps the risk level under check. Further, it is equally important that the fund house has a robust investment process and adequate risk management system in place.

3. Avoid timing the market - Time in the market is more important than timing in the market. Turbulent markets often cause investors to rethink their investment in equity mutual funds. In times like this, investors tend to make financial decisions by trying to time the market. But the fact is, no one can accurately forecast the market movement. This is because economic, political, social, and other factors that affect the stock market are highly unpredictable. Markets may continue to rise even if it is overvalued, and/or it could prolong its fall even after huge corrections.

4. Avoid buying/selling schemes based on short term performance - It is important to remember that past performance is in no way an indicator for future returns. A top performer of a particular year/market phase/cycle rarely appears as the top performer in the ensuing year/market phase/cycle. So instead of chasing returns, a better approach is to invest in schemes with steady performance regardless of market conditions.

5. Opt for the SIP route - When you are investing for the long term, it is important to adopt a disciplined approach. Opting for the SIP mode of investing enables you to do just that by investing regularly regardless of market conditions. Investing through SIP allows you to mitigate the impact of volatility, average out the investment cost, and optimise returns through the power of compounding.

These are unprecedented times, but that should not prompt you to stop or redeem your investments. Instead, ensure that you make mindful choices by aligning investment choices to your risk profile and investment objective. Lastly, do not forget to maintain an emergency fund to protect your finances from the impact of the pandemic. If you had used it during the first wave, gradually rebuild it so that you have at least 6-12 months' worth of expenses for contingencies.

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Warm Regards,
Divya Grover
Research Analyst

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