Mutual funds are a great way for a non-resident Indian (NRI) or a Person of Indian Origin (PIO) to participate in the growth of the country and reap benefits.
For those who have reaped some of those benefits, one question that consistently arises is which is better – those which are passively managed or actively managed?
But before that lets quickly brush through how investing mutual funds have been beneficial to NRIs around the world.
Mutual funds are a great way for a non-resident Indian (NRI) or a Person of Indian Origin (PIO) to participate in the growth of the country and reap benefits.
The main advantage for NRI investors buying mutual funds in India is foreign exchange benefits. That is if the Indian Rupee has gained on the currency of the country they live in, then the investor will be able to make more profits.
However, the downside of this is that if the Indian currency falls against the foreign currency concerned, then the profits could even be in the negative – but it need not necessarily be in the negative. If the decline in currency, plus inflation in greater than the gains in the mutual funds, returns could be negative.
However, the downside of this is that if the Indian currency falls against the foreign currency concerned, then the profits could even be in the negative.
A simple example of how forex rates can eat into your profits:
Let’s say an NRI from the UAE invests Dh15,000 in a mutual fund in India at an exchange rate of INR 20 to Dh1, which comes to about INR 300,000.
At the end of 7 years the original investment grows by 100 per cent, and the total amount remittable to the NRI is INR 600,000 (Dh30,000).
Now if the exchange rate from converting Dirham (AED) to Indian rupee has gone down at INR 19 (while the rupee gains) at the time of remittance after five years, then he or she will get around Dh31,578, but if the conversion rate has gone up at INR 22 (with declining value of rupee) then its Dh27,272.
Although there is no separate kind of mutual fund for NRIs to invest in India, many Asset Management Companies (AMC) offer NRI-targeted funds.
Alternatively, NRIs and PIOs can invest in India-focused mutual or offshore funds offered by AMCs in their own countries.
India-focussed offshore funds and ETFs are some of the eminent investment vehicles through which foreign investors invest in Indian equity markets.
NRIs and PIOs can invest in India-focused mutual or offshore funds offered by AMCs in their own countries.
Age-old debate
There has always been a furious age-old debate whether investors are better off with low-cost passive index funds compared to actively managed mutual funds.
To know which of the two one should opt for, let’s first know what the two are, before delving into what makes the two different and why either of them would make a better choice.
A passively managed fund, by contrast, simply follows a market index. It does not have a management team making investment decisions.
Actively managed funds may perform well in the short-term, passively managed index funds have higher returns over longer periods of time.
But before we delve deep into which would be better for you, we need to know what types of mutual funds are there and what makes the two managed funds different.
Types of mutual funds
There are many different types of mutual funds you can choose from. Some of the most popular are:
• Equity mutual funds: These funds invest in stocks. Most people who invest in mutual funds invest in equity funds.
These funds aim to grow faster than other funds, so there is usually a higher risk that you could lose money.
• Fixed income mutual funds: This type of mutual fund relies mainly on bonds — not a stock in a company but a kind of loan that the company (or a municipality, or a state, or the federal government) then pays back with interest.
These are going to pay out a lot less than a successful equity type mutual fund, but the risks are controllable by bond type.
• Balanced funds: These funds invest in a mix of equities and fixed income securities. They try to balance the aim of achieving higher returns against the risk of losing money.
Most of these funds follow a formula to split money among the different types of investments. They tend to have more risk than fixed income funds, but less risk than pure equity funds.
Balanced funds try to balance the aim of achieving higher returns against the risk of losing money.
Aggressive funds hold more equities and fewer bonds, while conservative funds hold fewer equities relative to bonds.
• Index mutual funds: These funds basically aim to track the performance of a specific market index (A market index is a metric that tracks the performance of a group of stocks).
This kind of mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.
• Specialty funds: These funds focus on specialized mandates such as real estate, commodities or socially responsible investing.
For example, a socially responsible fund may invest in companies that support environmental stewardship, human rights and diversity, and may avoid companies involved in alcohol, tobacco, gambling, weapons and the military.
Specialty funds focus on specialized mandates such as real estate, commodities or socially responsible investing.
• Fund-of-funds: These funds invest in other funds. Like balanced funds, they try to make asset allocation and diversification easier for the investor.
The expense of managing fund-of-funds tend to be higher than stand-alone mutual funds.
Examples of passively and actively managed funds
He pays a 0.06 per cent management fee. Max's fund is guaranteed to mimic the performance of the S&P 500.
When Max turns on the news and the anchor announces that the S&P rose four percent today, Max knows that his money did the same thing.
Similarly, if he hears the S&P fell five percent, he knows his money did the same. Max also knows that his management fee is small, and won't make a big dent in his returns.
Max understands there will be some very slight variations between his fund and the S&P 500 because it's nearly impossible to track something perfectly.
But those tiny variations won't be significant, and, as far as Max is concerned, his portfolio is imitating the S&P.
There will be some very slight variations between fund and the index because it's nearly impossible to track something perfectly.
Rob's actively managed fund buys and sells all kinds of stocks — banking stocks, real estate stocks, energy stocks, and auto manufacturing stocks.
His fund managers study industries and companies and make buy/sell decisions based on their predictions of those companies' performance statistics.
Rob knows that he's paying almost one percent to those fund managers, which is significantly more than Max is paying. She also knows that her fund won't track the S&P 500.
When a news anchor announces that the S&P 500 rose two percent today, Rob can't draw any conclusions about what her money did. His fund might have risen or fallen.
Rob likes this fund because he holds onto the dream of beating the index. Max is stuck to the index; his fund's performance is tied to it.
Max, however, has a chance of outperforming, or doing better than, the index.
After reviewing these examples, you can see the reality of how the two different funds operate so you can have a better idea of which might work for you.
Rob likes this fund because he holds onto the dream of beating the index. Max is stuck to the index; his fund's performance is tied to it.
Now let’s have a reality check of what’s been happening in the current market environment.
Reality for Indian mutual funds
Active funds have historically aimed to beat their benchmarks through careful stock selection but charge a higher fee for this effort.
Passive funds, on the other, simply mirror the index by investing in the same stocks in the same proportion. With no active management, these funds have much lower charges.
Proponents of active funds say the higher charges are more than made up by the excess return, or alpha, they are able to deliver.
On the other hand, supporters of passive investing say there is no point paying a high fee if active funds are lagging behind their benchmarks.
The two studies have thrown up contrasting results due to different methodologies and matter experts have pointed out flaws in both studies.
To put it simply, among the stocks in an equity mutual fund, each company stock provides varied returns each year. So, it’s in the hands of the manager to make sure the best stocks are opted for to provide optimum returns.
This is where the track record of the manager comes into play in your decision.
It’s in the hands of the manager to make sure the best stocks are opted for to provide optimum returns.
Varying performances
Let’s now look at another poll to know why the data in the above surveys (like others) showed varied results.
And by looking at what the study indicates, one will realize that not all actively-managed mutual funds beat the benchmark and which of them still do.
In India, the truth is large-cap funds have endured a torrid time in recent years.
The poll indicated that only two out of 28 active large-cap funds managed to outperform their chosen indices over the past three years. This reflects very poorly on active funds.
An interesting statistic, however, was as per the poll 80 per cent of multi-cap funds (a fund with a mixture of companies with different market caps) have reported outperformance over five years.
Investors staying put with multi-cap funds over five years have typically been rewarded.
Another observation was that the mid-cap funds category has struggled to deliver alpha in recent years. More than 50 per cent of active mid-cap funds have lagged the index over the past three years.
These funds have clocked much lower outperformance over three-year time horizons compared to five years.
Investors staying put with multi-cap funds over five years have typically been rewarded.
Small-cap funds, on the other hand, have reported 100 per cent outperformance across both three and five-year time periods.
Also, the funds comprising the newly created category of ‘large & mid-cap’ have fared rather poorly across time periods, both in terms of number of funds and the value of assets.
Merits to going passive
Besides the underperformance in active funds, experts point to other merits in going passive. With index funds or ETFs, investors do not have to worry about identifying the right fund.
Investing with an active fund requires careful evaluation of its performance track record.
Even after investing, one needs to be watchful for any prolonged dip in performance. There are enough examples of high-profile equity funds falling by the wayside over the years.
And market experts continue to warn that there is no proven way to identify an equity fund that can continue to outperform into the future.
Even after investing, one needs to be watchful for any prolonged dip in performance.
Another concern is the risk that a high performing fund manager can just move on. Active funds that depend excessively on an individual’s skill set rather than on established processes are at risk.
Meanwhile, there is no human intervention in index funds or ETFs beyond index-driven adjustments in the portfolio. Passive funds thus afford a degree of simplicity and relative peace of mind.
The essence of passive investing lies in its simplicity. Passive funds are more relevant for investors who prefer simplicity over the complications of identifying the right funds and monitoring their performance.
So now to summarize, let’s weigh out which is better with the pros and cons.
Pros and Cons
Perks of investing in a passive index funds
• Cost: The expense ratio of passive funds is on the lower side. Their expense ratio is around 0.1 per cent. It means that you do not have to incur significant costs because of the management of the fund.
The expense ratio of passive funds is on the lower side. Their expense ratio is around 0.1 per cent.
• Simplicity: There are no complicated algorithms or strategies at work when it comes to passive funds. They mimic the index in their portfolio holding.
The simple methodology helps you understand your fund’s investments. There is no confusion at all. It is one of the strengths of the passive index funds.
• Consistent returns: The index funds mimic the returns of the index. That is why such funds can provide you with long-term gains.
If you are a long-term investor, these are the best funds to choose.
Although there is some type of actively managed funds that may provide better returns, index funds a safer option for those looking for consistent returns.
Downside of investing in a passive index funds
• Limited returns: Passive funds provide the return as per the index. Owing to this very reason, they do not beat the market because they precisely mimic the returns of the market.
Passive funds do not beat the market because they precisely mimic the returns of the market.
• Concentration of top stocks: The investment of such funds has been often in the top 50 or top 100 stocks.Owing to this very reason, they usually have a high concentration of such stocks.
While it might not hamper the results in the long term, the lack of diversification is certainly a con which they must deal with.
• Rule-based: Passive funds typically employ rules-based investment strategies in which investments are effectively picked by a checklist.
These rules generally work, but when everyone rushes into one popular trade, it could create some imbalances that wouldn't necessarily happen if passive funds played a smaller role in the market.
• Inflexibility: Inflexible nature of passive funds means that they have to buy stocks by mandate.
That means that if money piles into a passive fund, it will just allocate the cash to the stocks it already owns, often paying higher and higher prices with no regard for relative value.
Inflexible nature of passive funds means that they have to buy stocks by mandate.
Now let’s highlight the perks of investing in an actively managed mutual funds
Index funds haven't yet caught on in the bond world because their rules-based methodologies don't work so well in less liquid, less standardized corners of the financial markets.
• Flexibility: Actively managed funds have complete flexibility to invest in a broad basket of stocks. They do not just have to stick to a particular index.
• Expertise: A fund manager’s expertise, experience, skill and judgment is being utilized when investing in an actively managed fund.
Actively managed funds do not just have to stick to a particular index
For example, a fund manager may have extensive experience in the automotive industry, so as a result, the fund may be able to beat benchmark returns by investing in a select group of car-related stocks that the manager believes are undervalued.
• Tax benefits: Actively managed funds allow for benefits in tax management.
The ability to buy and sell when deemed necessary, makes it possible to offset losing investments with wining investments.
Many high net worth investors invest in actively managed funds because when they incur a loss, they can easily get a tax break on it. It might not happen every year, but it happens once in a few years due to which they invest in it.
Risks of investing in an actively managed mutual funds
• Bad for long-haul: Studies show that most actively managed funds underperform passive funds over the long haul, primarily because of the difference in fees.
But it's a mistake to categorize all active funds as too costly to outperform.
• Higher Cost: The expense ratio of actively managed funds is on the higher side. It is due to the churning of the portfolio. It limits your returns to a certain extent.
• Human Error: There is a high probability of human error in actively managed funds. It is because the fund manager can easily go wrong with the choices of stocks in their portfolio.
• Minimum thresholds: Most of these fund managers have a minimum threshold. That is why it is not suitable for small investors.
How NRIs can invest in mutual funds in India
Non resident Indians (NRIs) can invest in Indian mutual fund schemes subject to provisions applicable in the Foreign Exchange Management Act.
The first step involves opening an NRE or NRO account. (NRIs can invest on repatriable or non-repatriable basis using funds from the NRE or NRO accounts respectively. You can read more about these deposit accounts in How good are Indian corporate versus bank fixed deposits?
Non resident Indians (NRIs) can invest in Indian mutual fund schemes subject to provisions applicable in the Foreign Exchange Management Act.
The NRI should complete KYC formalities by filling up a form and submitting documents. The papers must be attested by an authorized official who can carry out in-person verification.
A standard mutual fund application form needs to be filled by the NRI investor. Declarations such as FATCA and CRS should also be made.
Investments can be redeemed by following the redemption procedure mentioned by the fund. Redemption proceeds shall be credited to the respective NRE/NRO bank account of the investor.
Remember: If details of your bank account abroad are provided, the application will be rejected. Also, on redemption of units, tax will be deducted at source on the capital gains made on the investment.
