Market Downturn Exposes Weaknesses in Passive Investing, Strengthens Case for Active Fund Management
As equity markets experience heightened volatility, the performance of passive investment strategies has come under scrutiny. Traditionally considered a low-cost and stable option, passive funds have struggled to cushion investors’ portfolios during the latest market correction. Meanwhile, actively managed funds have demonstrated resilience, particularly in smallcap, flexi-cap, and multi-cap categories.
Nifty’s Market Correction and Its Impact on Passive Funds
The NSE Nifty 50 index, which touched an all-time high on September 27, 2024, has since been on a downward trajectory, leading to losses across various investment strategies. Investors who relied on smart beta funds—a hybrid between active and passive investing—expected risk-adjusted stability. However, data shows that many of these funds have failed to outperform traditional market-cap-weighted indices.
Performance of Key Smart Beta Indices During the Correction:
- Nifty Alpha Low-Volatility 30 Index declined 24.3% between September 2024 and February 28, 2025, compared to a 15.6% loss in the Nifty 50 index.
- Nifty Quality Low-Volatility 30 Index and Nifty Alpha Quality Low-Volatility 30 Index also underperformed against broader market benchmarks.
These findings indicate that smart beta strategies, designed to offer downside protection, have instead magnified losses for investors.
Why Passive Strategies Have Struggled in This Bear Market
Passive funds, including index funds and exchange-traded funds (ETFs), have witnessed a surge in investor interest in recent years, primarily due to their low-cost structure and the perception that they can deliver stable returns over the long term.
However, during this market correction, these funds have failed to provide the expected cushion. Experts attribute this to:
1. Back-Tested Volatility Models Not Matching Current Market Conditions
Passive funds relying on historical data for volatility assessment have struggled because past trends do not always predict future movements. According to Kirtan Shah, founder of Credence Wealth, smart beta indices are built on back-tested data, which may not reflect real-time market shifts.
2. Market-Cap-Weighted Indexes Holding Large Positions in Overvalued Stocks
Passive funds that track indices like Nifty 50 and Nifty 500 tend to mirror the weightage of overvalued stocks, exposing investors to greater losses when these stocks decline.
3. Limited Flexibility to Adjust Holdings During Market Downturns
Unlike active funds, which can adjust their portfolios based on market trends, passive funds rigidly follow the index composition, making them less adaptable in volatile markets.
Active Fund Management Outperforms in Bear Markets
On the flip side, actively managed funds have demonstrated stronger resilience, particularly in smallcap, flexi-cap, and multi-cap categories.
Findings on Active Fund Performance:
- Smallcap funds outperformed the Nifty Smallcap 250 Index in terms of average returns during the correction.
- Flexi-cap and multi-cap funds delivered better returns than the Nifty 500 Index, showing that fund managers successfully navigated volatility.
According to Amol Joshi, Founder of Plan Rupee Investment Services, many investors mistakenly believe that passive funds will automatically outperform active funds due to lower expense ratios. However, he clarifies that passive funds are not designed to minimize losses but merely to track the underlying index.
The Surge in Passive Fund AUM Despite Recent Underperformance
Despite the disappointing performance of passive funds during this market downturn, their assets under management (AUM) have continued to grow.
AUM of Passive Funds in India (as of January 2025):
- Total AUM: ₹10.91 lakh crore
- ETFs and index funds account for over 50% of new fund launches in 2024
While passive investing remains an attractive option for long-term investors, experts caution that blind reliance on passive strategies without considering market conditions can lead to suboptimal returns.
The Debate: Active vs. Passive Investing—What’s the Right Approach?
With active funds showing superior performance in volatile markets, many investors are re-evaluating their investment strategies.
Advantages of Active Fund Management:
- Fund manager discretion allows for better stock selection in uncertain market conditions.
- Flexibility to rebalance portfolios, reducing exposure to overvalued stocks.
- Ability to outperform benchmarks, especially in midcap and smallcap segments.
Advantages of Passive Investing:
- Lower costs due to reduced fund management fees.
- Elimination of fund manager bias, ensuring a pure market-tracking approach.
- Better suited for largecap investing, where stock-picking has limited advantage.
According to Deepak Chhabria, CEO of Axiom Financial Services, investors should not dismiss passive funds entirely but should instead adopt a balanced approach.
Chhabria’s Investment Strategy Recommendations:
✔️ Use passive funds for largecap exposure, where markets are highly efficient.
✔️ Opt for active funds in midcap and smallcap categories, where fund managers can generate alpha.
✔️ Diversify across strategies to create a well-balanced investment portfolio.
The Smart Beta Boom: Too Many Choices for Investors?
The explosion of smart beta fund options in 2024 has sparked concerns about whether too many choices are making investing unnecessarily complex.
Popular Smart Beta Fund Variants Launched Recently:
- Equal Weight Largecap Index Funds
- Top 10 Equal Weight Strategies
- Value-Based Largecap Indices
- Sector-Specific Smart Beta Funds
While these funds offer unique investment angles, industry experts caution against overcomplicating investment choices.
According to Kirtan Shah, investors should focus on keeping portfolios simple rather than chasing new fund variations.
Shah’s Advice for Investors:
🔹 Stick to traditional largecap, midcap, and smallcap funds for core portfolio allocation.
🔹 Avoid excessive fund switching, as frequent reallocation can lead to higher costs and inconsistent returns.
🔹 Prioritize risk-adjusted returns over chasing recent trends in fund launches.
Final Verdict: Striking a Balance Between Active and Passive Investing
The recent market correction has reinforced the importance of diversification. While passive funds have gained popularity due to their cost-effectiveness, they have also exposed limitations during downturns.
Highlights for Investors:
- Passive investing is not a guaranteed safeguard against market declines—it simply mirrors the index.
- Active funds have outperformed in the current downturn, particularly in smallcap and flexi-cap segments.
- A hybrid strategy that includes both active and passive funds can help maximize long-term returns while managing risk.
- Smart beta funds may not always deliver downside protection, making it crucial for investors to assess their risk appetite.
As market dynamics continue to evolve, investors should periodically reassess their strategies to align with their financial goals and risk tolerance.
