Add Passive Funds For A Healthy Portfolio Mix

Investing involves careful consideration of multiple avenues that suit our requirement which must be in-line with the risk appetite. Such combination not only ensures the achievement of set goals but also provide a pleasant investing experience. Among the various avenues, mutual funds form a popular one particularly dealing with equity assets. They’re a pooled investment options where the investors provide capital for long-term appreciation.

The investors are allocated units depending on their contribution to the fund and is managed by a regulated, competent and professional team. The benefits of economies of scale help investors to avail the benefits of professional management of funds at relatively cheaper costs. They’re also transparent for investors to know where the investments are parked and how they’re managed providing higher confidence. Due to this structure where the investors have no right to decide on the constituents of the fund and the discretion lies with the fund management, they’re seen as passive investment options.

However, there are two types of MF – active and passive. This classification is based on how the fund is managed i.e., in an active fund management, the decisions to operate and allocate the capital is at the discretion of the fund manager. The passive funds are those which virtually have no fund manager i.e., the fund invests in an index or an ETF (Exchange Traded Fund) and so is passively managed. The very objective of the former is to achieve better performance than the benchmark or index.

Per the regulation, each fund is categorised and has a benchmark to be juxtaposed against. So, an active fund manager while playing within the said category strives hard to achieve and outperform the benchmark. This requires a consistent effort on how the portfolio is responding to the changing market conditions, accordingly, make variations to make better out of the situation. The fund manager backed by the research team allows them to keep tab on the fund portfolio and even churn depends on the requirement, which incurs costs which is reflected in the fund management costs, in-built in the NAV of any fund.

In a passive fund like an index fund, the role of the fund is to mirror the performance by replicating the index. It aims to replicate the movement of an index of a specific financial market, or a set of rules that are held constant, regardless of the market conditions. These are a type of mutual funds with a portfolio constructed to match or track the components of a market index, such as the Sensex or Nifty BeES. An index fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.Thus, these funds incur a relatively lower management fee than active funds.

While investing in an Index fund, one should look beyond the expense ratio and hence consider the tracking error. The tracking error is the deviation between the returns generated by the fund and the underlying index. A good Index fund has a minimum deviation from that of the index. But there is an important argument against the Index funds, especially with a lot of underperformances when compared to an actively managed fund tied to the same index. Higher market capitalisation by a stock ensures its way into the index. In other words, when you invest in an index, Sensex per se, one would buy a basket of expensive stocks, thus moving away from the principle of value investing. The returns thus earned from a stock are a function of its purchased price, so, higher the purchase price, lower the returns. As one buys the index, the returns could be sub-optimal. This could be damaging with the stocks in the index being churned i.e. existing ones moving out and being replaced by another stock. This is particularly stark where the indices are capitalisation based, which usually most are.

Bogle, the founder of Vanguard, which launched this revolution of index investing has a word of caution on overdoing of these funds by the investors. He contended that if the historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large corporation. One outcome is that large passive investors maynot be as invested in the performance of a single company as asset managers who’ve more riding on the performance of one company. In that scenario, they may not exert as much oversight and pressure as an active investor.

A healthy blend involves exposing to the index funds where a sector is still evolving and has limited stock opportunities and/or those where the segment of active funds are underperforming the benchmark. In India, we’ve witnessed in the recent years where the large-cap active funds have underperformed to their benchmarks. This is one area an investor could take advantage of the passives. Also, when one is exploring a particular theme/sector or micro-cap stocks and even eyeing an international exposure like that of S&P 500 or NASDAQ could use these through the MF index offerings.

(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])