Greetings from Team Carnelian!
Passive investing has been emerging as an alternative to active investing given the reason that a large universe of active fund managers underperform their respective benchmarks post expenses. Propagation of passive funds by some large legendary investors (who have created wealth by active investing) has further added to the popularity of passive funds.
While passive funds have worked well in a mature economy, that might not be the case universally. We strongly disagree that passive investing is better than active investing and bring a differentiated perspective to the concept of passive investing.
Let’s start with a basic question, can passive investing exist without active investors? Imagine a world without active investors! Outcome of active investing leads to passive investing. The actions of active investors create indices which are followed by passive investors much later. The outcome of participation in compounding journey with a lag, dilutes the magic of compounding to a large extent. Compounding calculations suggest an alpha of ~3% on INR 1 crore over 30 years is INR 70 crores.
We argue that Passive investing can lead to missing sizable alpha creation opportunities:
Passive investing fails to capture underlying transformation happening in the economy.
Whenever any economy goes through the transition & is in the transformation phase, it creates new sectors and opportunities, which by very nature cannot be part of the index immediately. It takes a long time before they are included in the index due to the very nature and process of index construction. If one were to only follow passive index investing, one would miss out on capturing those sizeable wealth creation opportunities or it will have to wait till they are part of index investing. Let’s see some examples:
Prior to 1991 liberalization, the Index largely consisted of old economy stocks flourishing during the License Raj. Post reforms, the services sector began to boom. Anyone who invested in the index then would have missed multi-bagger opportunities in Financials and IT for a long period of time. Financials were 20% of Nifty in 1995, went on to become 33% now, IT was not present at all in 1995, it currently forms 14% of Nifty. Massive wealth creation has happened across both these sectors; specific stocks have delivered multi-bagger returns.
Active investing involves capturing the underlying transformation happening in the economy/sectors and picking up emerging leaders. Individual sectors tend to outperform immensely during their respective periods of tailwind. Outsized allocations can only be taken when one has a conviction on the underlying transformation. Funds end up creating massive alphas for their investors by taking sectoral calls. E.g., Magellan in US, Mirae MF/erstwhile Reliance MF in India. If one is able to pick up sectoral leaders early returns can even be higher than the sector CAGRs.
Our active calls have resulted our YnG, Bespoke, Shift & Compounder funds delivering 32.7%, 24.4%, 21.7% & 7.8% alpha CAGR respectively post expenses.
2. Passive investing is momentum investing essentially
Another interesting aspect to note about passive investing is - Indices include stocks which have outperformed and drop the underperformers in the periodical rebalancing, which is akin to momentum investing - buying stocks after a good run (usually at high valuations) and selling post sharp fall (usually at low valuations). Our analysis suggests a large part of value creation in the stocks happens prior to inclusion in the index, whereas a large part of value destruction happens prior to exclusion.
Hence a passive investor not only misses the initial rally in structural stories, but also participates in a large part of the value destruction before the stock gets excluded. e.g. Indiabulls Housing was included at INR 51,000 cr. market-cap on 31-Mar-17 and got excluded at INR 11,600 cr. on 27-Sep-19. Yes Bank was included at price of INR 163/share on 27-Mar-15 and was excluded at INR 54/share on 19-Mar-20 (adj. for bonus/split/capital raise).
We conducted a study of 48 stocks of which 25 have entered and 23 have exited Nifty since 2015. Our findings indicate stocks appreciate far more before entering the index v/s when they are part of the index. Out of the inclusion of 25 stocks., 76% of stocks have generated >20% CAGR returns in the 5 year period before they entered the index. The element of alpha lies in finding the stock before the market discovers it. Index stocks are already discovered by the market (active fund managers😉)
Most of the stocks gave better returns after they got dropped from the index v/s during last 5 years before exclusion. It is important to understand that earnings growth and valuations are not given any consideration when determining constituents of the index.
“Investing in a good company and investing in a good stock are two different things.” - Howard Marks
Another interesting aspect is - Index investing essentially happens at market weighted prices. Hence, higher allocation happens at higher prices and less at lower prices. “So, you buy more weight of a stock at a higher price – a counter to fundamental investing based on Risk Reward Framework”. It is shocking to note that out of 23 stocks that exited Nifty over last 9 years, 15 stocks exited below their inclusion price. This happens because passive investing does not give any regard to industry tailwind, management quality, growth opportunities, balance sheet metrics and other such fundamental aspects of investing.
Alpha generation in US during transformative phase 1970s-90s
Even if one were to see, US was a comparatively high growth economy from 1970s-90s; sustainable healthy growth on a large base gave the opportunity for new sectors to emerge and grow. Despite the energy crisis in 1979, Vietnam war (1955-75), Black Monday in 1987 and many other such events - a larger proportion of active fund managers outperformed the benchmark. This ratio has fallen off as the growth rates have cooled off.
1970-80s was a period where US financial markets saw many STAR FUND MANAGERS to the likes of Peter Lynch, John Templeton, John Neff, James Simons emerge. These fund managers generated sizeable alpha over the index. Peter Lynch’s Magellan Fund went up from USD 18mn in 1977 to USD 14bn in 1990, delivering ~29% CAGR returns during 1977-90 vs ~14.8% at the index level. Can you imagine what impact it can make on the compounding of your portfolio?
Is Active Investing worth the effort?
The benefits of patience and compounding of small efforts are seldom given the required importance. People often ignore the importance of “r” and “t” in the compounding formula. Even though investors understand as to what is compounding, but more often they fail to implement it commercially in a real sense. Street smart fund managers will end up having >3% - 6% alpha. INR 1 crore compounding for 30 years at 14.5% p.a. results in a corpus of ~INR 58cr. However, with just ~3% higher returns p.a., the corpus explodes to ~INR 125cr (>2x at the end of 30-year period). At ~5% higher returns, wealth creation is ~3.5x vs the index level. It is difficult to understand the impact of Year-30 standing at Year-0 – which is where people end up not implementing compounding in a real commercial sense. We very strongly believe that stock picking and active investing are worth the effort. The difference clearly becomes visible as one expands the time horizon.
India – Plethora of alpha generation
It is extremely important to understand and realize that India is the only large democratic economy (USD 3.8 tn GDP) growing consistently at mid to high single digit. This is because of the deeply engrained structural facets of the country. India is undergoing a transformative phase where India will become a developed nation in the next 25 years. Whenever any nation travels this journey, it creates a broad based, diverse opportunity set, which is difficult to capture by passive investing.
For example, believing that it is India’s decade of “Manufacturing” on the back of well laid out factors, we identified the “Manufacturing” theme way back in Oct 2020 and launched the “Carnelian Shift Strategy”. This strategy has delivered ~47.7% CAGR and an “alpha” of ~21.7% p.a. since inception. Could one imagine the impact of this on compounding?
We rest our case. We will continue to make & pursue our case for Active.
India is poised for its “Amritkaal”.