A compelling story has emerged in the financial world: since markets are becoming more efficient, the most logical investment strategy is simply to follow an index. We’ve all heard it, the pitch for passive investing. It’s low-cost, it’s automated, and it has been championed by legendary investors who, ironically, built their own massive fortunes through active, high-conviction bets.
But at Carnelian, we believe that applying a mature market playbook to a transforming market is a fundamental strategic error. While passive funds have undeniably worked well in stagnant or highly efficient Western economies, the Indian context demands a different perspective.
We don’t just prefer active investing; we argue that in an economy like ours, passive investing is inherently a lagging strategy. Here is why the set it and forget it approach might be costing you the most significant wealth-creation opportunities of your lifetime.
In this article, let us understand its role in active management and why PMS Strategies are gaining traction among HNIs?
The Paradox of Choice: Can Passive Exist Without Active?
Before diving into the numbers, we must address a basic philosophical question: Can passive investing even exist without active investors?
An index does not exist in a vacuum. It is a mathematical shadow cast by the collective decisions of active participants. The outcome of active investing is what eventually becomes the input for passive funds. When you buy an index, you are essentially following the footsteps of active managers who have already identified growth, allocated capital, and driven the price discovery process.
By the time a company is proven enough to enter a major index, the most explosive phase of its compounding journey has often already occurred. In a sense, passive investors are joining the party just as the early-bird specials are ending.
Missing the Magic of Transformation
India is building a brand-new foundation for its future. As we journey toward becoming a developed nation over the next 25 years, we are seeing the birth of entirely new sectors from specialized manufacturing and green energy to digital infrastructure. By their very design, passive indices are backward-looking. They are built on historical data, market-cap hurdles, and liquidity rules. This creates a significant Inclusion Lag:
The Sector Gap: When an economy develops, new sectors emerge. These sunrise industries cannot be part of the index immediately.
The Opportunity Cost: If you only follow a passive index, you are structurally barred from owning the next generation of leaders until they have already scaled.
Active investing is the art of capturing this transformation in real-time. It’s about identifying the emerging leaders before they become household names.
Data tells a compelling story. At Carnelian, our findings indicate that stocks tend to appreciate far more before entering an index than after.
Consider this: In a study of 25 major stock inclusions, 76% of those stocks generated a CAGR of over 20% in the five-year period before they joined the index. When you invest passively, you miss that of high-velocity compounding.
Furthermore, the mechanics of index rebalancing often look a lot like momentum investing at the wrong time. Indices add stocks after they’ve had a massive run (often at peak valuations) and drop them only after they’ve suffered a significant fall. Case in Point: Look at the history of companies like Indiabulls Housing. It was included in the index at a ₹51,000 crore market cap and finally excluded when it had crashed to ₹11,600 crore.
A passive investor doesn’t just miss the initial rally; they are forced to participate in the value destruction all the way to the bottom because the rules haven’t triggered an exit yet.
Buying High and Selling Low: The Flaw of Market-Cap Weighting
One of the most touted benefits of passive investing is its simplicity. However, that simplicity hides a fundamental risk-reward flaw. Passive indices are market-cap weighted, meaning you automatically buy more of a stock as its price goes higher and less as it goes lower.
As Howard Marks famously suggested, this is the exact opposite of fundamental investing. Fundamental investing is about identifying a disconnect between price and value. Passive investing ignores the industry tailwinds, management quality, and balance sheet health, choosing instead to double down on whatever is currently the most expensive.
In the math of wealth, $A = P(1+r)^t$, most people focus on ‘P’ (the principal). But the real magic lies in ‘r’ (the rate of return) and ‘t’ (time).
Passive proponents argue that the difference in ‘r’ (the alpha) is too small to chase after fees. We strongly disagree. In a transforming economy like India, the alpha isn’t just 1% or 2%. The gap between a transformed sector leader and a stagnant index giant can be massive.The Math of Alpha:An alpha of just 3% on a ₹1 crore investment over 30 years isn’t just a small bonus.It is the difference between a comfortable retirement and a multi-generational legacy. That 3% extra can lead to an additional ₹70 crores over three decades.
Why India is Different
The Passive is King argument was born in the US, where the economy is mature, and information is disseminated almost instantly. India is different. We are a broad-based, diverse opportunity set that is still being mapped.
Whenever a nation travels the journey from developing to developed, it creates pockets of inefficiency that active managers can exploit through:
Forensic Analysis: Avoiding the value destroyers before they hit the index.
Management Quality Assessment: Backing the visionaries before the numbers show up on a screen.
Tailwind Identification: Positioning capital in sectors that aren’t yet index-heavy.
Access to letter for investors here for more deep insights.
The Carnelian Verdict
Passive investing is not wrong, but it is incomplete, especially for those seeking to maximize the Indian growth story. It is a strategy of defense, whereas wealth creation in a transforming economy requires a strategy of high-conviction offense.
Active investing isn’t just about trying to beat the market. It is about having the flexibility to ignore the losers, the foresight to buy the future leaders, and the discipline to capture the Magic of Compounding from day one not year five.
FAQs
1. Is passive investing safer for a large corpus?
No; a large corpus needs active risk management to avoid being over-exposed to a few expensive index giants.
2. What is the first step to moving from a passive to an active strategy?
At Carnelian, we conduct a comprehensive portfolio audit to identify if you are merely tracking the market or capturing the transformation.
3. How does the Inclusion Lag affect my investment returns?
Passive funds only add stocks after massive growth; active management captures this growth early on.
4. How does Carnelian actively manage the portfolio?
Carnelian actively manages portfolios by applying their investment philosophy which is “Quality growth at reasonable price” and then strategically blending Magic stocks with steady Compounders to maximize risk-adjusted alpha.
5. What is the recommended time horizon for a PMS strategy?
To truly witness the power of the compounding formula and market cycles, a minimum horizon of 5 to 7 years is recommended.
Didn’t answer your queries? Let us connect over a call.
