Should your investment be active vs passive or both?

Currently, a story is doing around in social media and online is that Warren Buffet, the legendary investor, made a million-dollar bet with Seides, a hedge fund manager, that the S&P 500 will beat a basket of fund of hedge funds over the next 10 years, ending last year. Seides conceded his loss, before the end of the 10-year period of the bet. This story has further fueled public interest in the active versus passive investment debate.

Passive investing means buying funds that closely track certain investment index such as Nifty, BSE Sensex, Bank Nifty etc. These funds invest in the stocks listed on the index in the same proportion as they form part of such index. The fund’s objective is to closely match the performance of indices that they are tracking. Whereas in the active investment funds employ large research team to help them select winning stocks, which would then generate greater wealth for investors. Nevertheless, the above story clearly shows that active investment lags the performance of the passive investment.

So, does this mean that you should go all out for passive investments? The answer to this is ‘no’. Although on an average passive investment has outperformed the active investment in various markets, there are certain pockets where they fail to match the performance of the active investment. One such pocket is an investment in small cap and mid cap dedicated funds.According to data sourced from valueresearchonline.com, dated January 15, 2018, in last trailing 10 years, active funds dedicated to small-cap and mid-cap stocks have outperformed indices of small and mid-cap stocks such as S&P BSE Small Cap and Nifty Free Float Midcap 100 Index.

One of the reasons for such outperformance is asymmetric information available for this small-cap and mid-cap companies, which is well utilised by fund managers to create alpha for their investors. Moreover, we are already into a three year of bull market and it has been experienced that passive strategy does better in early days of the bull market as there is a lot of correlation among stocks. Nevertheless, as cycle ages, the correlation falls, and it is the active strategy that stands a better chance of creating better returns.

Therefore, the ideal way of investment is not either active investment or passive investment, but a mix of both. A large part or core of your portfolio should go to low cost ETF or index funds and remaining should be divided among good performing small and mid-cap dedicated funds.