Can active investing ever work for you?

Let’s talk about active investing vs passive investing.

Passive investing is an investment strategy that is based on taking long positions on the market in general (pegged to an index like S&P 500, STI, Nifty or ASX 200) rather than taking specific positions in the market. Active positions is quite the opposite — the fund manager tries to *beat* the market by taking positions that is somewhat different than the market position and then constantly work on it by selling and buying based on market and company conditions.

The accepted wisdom is that passive investing is better than active investing for retail investors. Active investors on an average perform about as well as the market does. This shouldn’t come as a surprise because if one active manager takes a long position on something, say stock A, then someone else is taking the opposite position, either by shorting it or by staying away. Either way, the second manager is going to lose out if A performs better than the market and vice versa. So if the sum of all manager positions constitute the market, then if there are winners, there have to be losers, relative to the market, that is.

However, since the fund managers charge you a fee for managing your funds, the average retail investor loses out compared to the market, since he is going to get market return *minus* management fees. So, just tracking the market without paying the fees is much better than doing it by paying additional fees.

Active management fees are roughly 2–3% of the portfolio. So, if your portfolio returns 10% (S&P 500’s 50 year return), then you pay 30% of your returns to the average fund manager for doing nothing better than return market returns. Passive funds, like index trackers and ETFs, typically charge about 0.25%. So you give away 2.5% of your annual earnings — a far better deal.

So far, so good. However, there are a few interesting exceptions.

I have been invested in Franklin India Prima Fund for a while and the performance of its fund relative to its benchmark is quite spectacular:

First state dividend advantage vs STI ETF is another example:

I admit that these are exemplar funds and have to be compared against the vast majority of funds out there, but the point I am trying to make is simple — you are not going to invest in every fund out there. You are going to invest in a few. If those happen on the right side of the returns tables, you will earn a better return. What happens to the rest of the fund industry is none of your business.

The best way to identify a fund is to experiment, start by investing a small fund and observe how it does. If it does well, keeping adding to your position. If it doesn’t, walk away. The extra effort and experimentation might just pay off.

Of course, you can always invest in passive, index tracking funds, and still walk away better off than not investing at all, at least in the long run.