Why you should avoid active mutual funds

The biggest reason I recommend against actively managed mutual funds is that most investors have a time horizon much longer than any AMC’s or the fund manager’s.

Assuming you start investing when you’re 40 and you live up to 80, your retirement portfolio has a lifespan of 40 years. Quite a few people will have portfolios with a longer time frame. Many would start investing at a younger age; many would want the retirement corpus to last for an additional decade or more. A lifespan of 50 or 60 years for a retirement corpus is not unusual.

It’s fairly easy to shortlist active funds that are great today. There’s a reasonable chance that these funds will stay good for the next 10 or 20 years. But change is inevitable. AMCs change hands; fund managers switch jobs; fund managers retire; investing landscape changes; regulations change. In a constantly changing world, it’s impossible to tell which of today’s top active funds will remain good 30, 40, 50 years from now.

A passively managed portfolio will never give you amazing, market beating returns, but the characteristics of such a portfolio won’t dramatically change later on. Anyone that likes a predictable portfolio over an unpredictable one should seriously consider passive management. (This is predictability relative to the market. A passive portfolio that replicates the market will always have the same amount of risk and return as the market itself. The risk and return of active portfolios can drift in either direction.)

While that’s my stance in general, I still use and recommend some actively managed funds. They are often hybrid or multi-asset funds that can act like “one fund portfolios” (meaning that’s the only fund you have in the entire portfolio).

• I use such funds to hold cash for a short duration (such as a few years). 
• I also recommend such funds to people who wouldn’t get any equity exposure otherwise. The chosen active fund may not be the best available, but if it’ll generate more return than a bank deposit. That’s often good enough.

The case for investing in NPS

I used to strongly recommend against NPS (National Pension System) because it doesn’t offer much flexibility to investors. It took me a while, but I eventually understood that NPS is a mass market product, and hence, it needs to account for the quirks of the “common people”. Recently I came across a few news stories that confirmed this.

News story 1: A vegetable vendor named Pradipkumar Vaishya has invested ₹4.55 crores in a Ponzi scheme called Torres. Reportedly, this capital belonged to him and others who invested through him. Torres shut down, taking with it many crores of rupees from investors like Pradipkumar Vaishya.

News story 2: A retiree has invested his entire life savings in an invoice discounting platform. He lost all his money when the firm shut down without notice. Many other investors have lost their capital too.

When looking at all this, it makes sense that NPS forbids people from squandering their retirement corpus. If falling for outright scams is one way to lose money, making emotional decisions is another.

You retire with a corpus that looks huge (but in reality it may be just enough to keep up with inflation). Someone in your family wants to borrow 10 or 15% of your corpus for some need. You think you have more than enough, so you lend it to them. They are never able to return the money. Inflation does its thing, and you are penniless in your final years. Or, maybe the borrower returns the capital without interest after 10 odd years, and you have lost a significant amount of interest that could have somewhat bridged the gap between inflation and your corpus.

A typical “common person” in our society is not good with money management. They are especially bad when it comes to living for a few decades off a corpus. Living off a corpus is a qualitatively different skill than managing one’s expenses with regular (or even irregular) cash inflow. Life doesn’t prepare us for it; we need to figure it out after we have retired. The vast majority of us will make mistakes. Some (many?) mistakes can have irreversible negative impact. It is an extremely hard problem.

NPS acknowledges this challenge and forces people to take a monthly pension. Even if the investor squanders all the money they have access to, the pension corpus stays intact and they’ll continue to receive some monthly cash flow.

I have strong opinions about how to invest my money. You—someone reading a blog post like this—also likely have strong opinions. NPS is most likely incompatible with our ideas and goals, so NPS is probably not a good fit for us. But we are outliers. For most people, NPS is a fine choice.

Holding RSUs because ‘they are there’

It is said that George Mallory, an English climber, was planning to climb Mount Everest for the third time. A reporter asked him why George Mallory wanted to climb again, and his reply was, “Because it’s there.” He wanted to climb the mountain because it was there.

Similarly, employees who receive RSU shares of their employer companies hold on to those shares. Ask a Microsoft employee if they want to hold Amazon.com shares. They’ll say No, but they’ll continue to hold their Microsoft shares. Ask a Facebook employee if they want to hold Walmart shares. They’ll say No, but they’ll continue to hold their Facebook shares.

These shares are held by those employees not as investments, but merely because “they are there” in their RSU accounts. If you are holding onto RSU shares of your present or past employer, ask yourself whether you are holding them because they are there or because you have a well thought out reason to hold them.

Correlation of assets in my portfolio

My investment portfolio has 4 assets: global equity, Indian equity, Indian bonds, and gold. I didn’t put this portfolio together myself; my financial advisor recommended this to me. I hesitantly took his recommendation because I couldn’t tell how good/bad this portfolio mix was.

I have been learning about portfolio construction for the past few months. As I learn about portfolio construction, I keep evaluating this portfolio—and I see that this is a great portfolio.

Recently, I have been thinking about asset correlation and how uncorrelated or negatively correlated assets make up resilient portfolios. Naturally, I checked the correlation of the assets in my portfolio. This is what I got, and as you can see, +0.3 is the worst correlation.

	US equity	Sensex	ABSL income
US equity	-
Sensex	0.3042	-
ABSL income	-0.2025	-0.4045	-
Gold	-0.4006	0.0400	0.0784

Notes about the data used to calculate the correlation. I couldn’t get data for the very specific assets I am investing in, so I used substitute data where necessary.

• I got US equity return data from the ‘Toolkit’ spreadsheet of portfoliocharts.com. This is the substitute for global equity data.
• For Indian equity, I am using Sensex data. I invest in a much broader index than Sensex, but this was the data I could get.
• I couldn’t get Indian bond return data, so I used the NAV history of the oldest debt fund, ABSL Income fund.
• The correlation is calculated based on their calendar year returns from 1996 through 2023.

Are “debt like” mutual funds better than pure debt funds?

Many thanks to Sayan Sircar for helping me understand many concepts that led me to eventually write this blog post.

Ever since the Indian government decided to tax debt mutual fund gains at the slab rate, I have been struggling to decide on a course of action. My initial intuition was that we should invest in the chosen assets and not worry about taxes. Then I changed my mind and I was attracted towards “debt like” funds that invest a significant portion of the capital in arbitrage.

But I had a constant nagging in the back of my mind because:

1. Arbitrage is constant work (for the fund management team) while debt funds are not as much work. I like the passive style of investing where “buy and hold” is the norm.
2. Arbitrage may not make as much money in bear markets (since futures may not sell at a good premium).

Arbitrage behaves differently than bonds, and I don’t exactly want arbitrage in my long-term portfolio. Until today, this was mostly intuition, but now I have some data to back it up. To make sense of that data, we must first understand correlation.

A primer on correlation

Correlation quantifies how 2 different investment assets behave relative to each other. A correlation of 0 means uncorrelated. When one asset’s movement doesn’t affect the other, we say they are uncorrelated. Cash is uncorrelated with all other asset classes.

Positive correlation means the assets move in the same direction; negative correlation means the assets move in opposite directions. We don’t want the correlation to be close to +1.0, which means the 2 asset classes behave mostly the same. That means there is no effective diversification.

A correlation close to -1.0 means the 2 asset classes cancel each other’s appreciation and we’d often end up with net zero return. This may sound unappealing, but rebalancing such a portfolio can be very rewarding. (In other words, such portfolios offer high rebalancing bonuses.)

Correlation between a few Indian mutual fund categories

I tried to get data for a few decades, but my attempts failed. ValueResearch provides calendar year returns for the last 9 years (2016 through 2024) at the fund category level. 9 years is not a long time period, but this is probably okay since this period includes both low and high interest rate markets. One interest rate cycle is better than zero! 😅

The correlation between mutual fund categories are shown in the following table.

Large cap : Arbitrage	-0.0312
Flexicap : Arbitrage	-0.0114
Large cap : Liquid	-0.2562
Flexicap : Liquid	-0.2593
Large cap : Short duration	-0.1700
Flexicap : Short duration	-0.1264
Large cap : 10-year gilts	-0.3884
Flexicap : 10-year gilts	-0.3740
Large cap : Dynamic bond	-0.3593
Flexicap : Dynamic bond	-0.3017

I had the intuition that arbitrage was similar to cash. The data confirms my intuition since arbitrage has a correlation (with equity) very close to 0. Shorter duration debt funds have correlation closer to -0.25 while longer duration debt funds have correlation closer to -0.4. (The Short Duration category falling between liquid and arbitrage is probably an anomaly caused by the small sample size of data we are working with.)

This is the metric I had to see to convince myself that pure bond funds are a better asset class to mix with equity. The lower correlation with equity means that an equity+bonds portfolio will have lower drawdowns than an equity+arbitrage portfolio.

My recent analysis quantified that the difference in post-tax growth rate is in the range of 0.5% to 1.5% annually. The difference in growth rate reduces as the holding period gets longer and longer. If we assume that a dynamic bond fund returns 0.5% more on average than an arbitrage+bond fund, then the net corpus won’t be very different between the 2 options.

Conclusion

1. Bonds, especially longer duration bonds, are a good asset to mix with equity. While arbitrage behaves like cash, bonds can provide meaningful downside protection (and provide meaningful rebalancing bonus).
2. For holding periods of 2 or more decades, the post-tax growth rate of bond funds is not too far from the post-tax growth rate of arbitrage+bond funds (source).
3. If we hold longer duration bond funds (such as dynamic bond funds), it is not unreasonable to expect that they’d yield 0.5% more return than arbitrage+bond funds. This further diminishes the difference in post-tax return.