Active vs index funds: Which strategy protects your investments better?

Investing in the stock market can be both rewarding and challenging. Investors often face the dilemma of choosing between active funds and index funds. While index funds offer simplicity and low fees, active funds provide a dynamic approach that can be particularly advantageous during market corrections. 

This article explores how the active management strategy can shield investors from sharp market downturns, which is inherently difficult for index funds to achieve.

Active funds vs index funds

Active funds are managed by professional fund managers who make decisions based on research, market conditions and forecasts. They aim to outperform the market by selecting stocks that are expected to perform better than average. Most importantly, active funds can adjust holdings based on market conditions. As against this, index funds are passively managed and designed to replicate the performance of a specific index (for example S&P BSE 500 or Nifty 50). They hold a fixed portfolio of stocks as per the index composition. Low cost and simplicity are major advantages of passive funds, but they lack flexibility.

Active fund – downside protection

Tactical asset allocation: Active fund managers have the discretion to alter the fund’s asset allocation. During signs of an impending market correction, they can reduce exposure to equities and increase holdings in more stable assets such as bonds or cash. This tactical shift can mitigate losses when the market takes a downturn.

Example: During the 2008 financial crisis, some active fund managers significantly reduced their exposure to financial stocks and moved into more defensive sectors such as consumer staples and healthcare, thereby reducing the impact of the sharp market decline.

Stock selection and sector rotation: Active fund managers can rotate out of overvalued sectors and into undervalued or less volatile sectors. This proactive stock selection can help cushion the fund’s performance during market corrections.

In early 2020, as the covid-19 pandemic unfolded, certain active funds reduced their holdings in travel and leisure stocks, and increased investments in technology and healthcare companies that were better positioned to thrive during lockdowns.

Cash allocation: Active fund managers can increase their cash holdings during volatile periods. This provides a buffer and allows them to buy stocks at potentially lower prices during a correction. Index funds are always fully invested, limiting this strategy.

For example, Aequitas is sitting on 20% to 25% cash, and Buoyant increased its cash holding to 15%-20% in the first quarter of 2024.

Why index funds fall short?

Lack of flexibility: Index funds are tied to their benchmark indices. They do not have the flexibility to move out of sectors or stocks that might be heading towards a downturn. This rigidity means that during a market correction, index funds will follow the market without any form of protective manoeuvring.

Also, if a stock becomes overvalued, it actually starts carrying more weight in the index. Unfortunately, this is just when astute investors would want to be lowering their portfolios' exposure to that stock. So, even if you have a clear idea of a stock that is overvalued or undervalued, if you invest solely through an index, you will not be able to act on that knowledge.

Inherent market risk: Since index funds are fully invested in the market at all times, they are exposed to market risks. When the market undergoes a sharp correction, index funds mirror the decline of the market, leading to significant losses for investors.

No defensive strategies: Index funds do not engage in defensive tactics like reducing equity exposure, sector rotation, or hedging. This absence of defensive strategies leaves investors vulnerable during periods of high volatility.

Role of active funds during major corrections

The Dot-com Bubble (2000-2002): During the dot-com bubble burst, active funds that had limited exposure to the technology sector. or had moved to more traditional value stocks, performed better than the tech-heavy indices like NASDAQ. Fund managers who anticipated the overvaluation in tech stocks were able to shield their investors from the full brunt of the correction.

The covid-19 pandemic (2020): At the onset of the pandemic, active funds with managers who quickly recognized the impending economic impact reallocated their portfolios. For instance, moving into technology stocks, which benefited from the shift to remote work and digital services, allowed these funds to recover faster compared to index funds that remained fully exposed to the broader market crash.

Also Read: Active vs passive funds: Can both play a role in your portfolio?

While index funds offer a low-cost and straightforward investment strategy, their inherent inflexibility can be a disadvantage during sharp market corrections. Active funds, with their dynamic management, provide a proactive approach that can protect investors from significant losses. Understanding the strengths and limitations of both active and index funds is crucial for investors in making informed decisions that align with their risk tolerance and investment goals.

Anuragg Jhanwar is partner and  co-founder, Upwisery Privaye Wealth. Views are personal.

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