Passively managed funds and portfolio allocation

The crux of your investment portfolio is allocation to various investment assets like equity, bonds, gold, etc. Within these are sub assets e.g. large cap/small cap stocks, long maturity/ short maturity bonds, etc.

There is another approach to portfolio allocation. There would be a core part of portfolio, and a satellite component. The core component is not to be disturbed unless there is a drastic change in the market or in the fund.

The satellite component is for taking tactical calls based on prevailing market situation. It is meant for taking advantage of extant market situations, and therefore the investment tenure can be short term. The more defensive the portfolio, the higher should be the core component as satellite is for taking higher risks.

Passive funds

The concept of passive funds is the fund manager does not take any decision on the portfolio. S/he does not take any decision on what to buy or when to sell. The fund manager’s job is to follow the underlying index. As an example, if the underlying index is Nifty50 or Sensex, then the fund manager will mimic that. S/he will buy the same stocks as in Nifty/ Sensex, and maintain the same ratio in portfolio allocation. The returns, which simply follow the underlying index, will be similar as of the index. The returns will be marginally lower as there would be some recurring expenses in the fund and tracking error.

Passive funds are available for various asset classes viz. equity, debt (bonds) and commodities. One passive idea or strategy can be followed by multiple Asset Management Companies (AMCs). Example, Nifty50- or Sensex-based passive funds.

Two formats

Passive funds are offered in two formats. One is Exchange Traded Funds (ETFs) where fund units are listed on the exchange i.e. NSE/BSE. Investors can buy/sell ETF units during trading hours. There is no purchase or redemption with the AMC for ETF units. The other format is Index Fund format, where you can buy or redeem with the AMC, like any other open-ended fund.

The advantage of Index Fund format is liquidity; when you want money, just make the redemption request. In ETFs, the advantage is you can do multiple buy/sell trades a day. In Index Funds, you can buy/redeem only once a day, at end-of-day NAV.

Active vs. passive

There is a debate between active and passive funds, which one is better? In active funds, expenses are higher. The expectation is, these funds would generate returns higher than relevant benchmark, which is referred to as alpha.

If the active fund is not beating the benchmark, then why should the investor bear higher expenses? The investor would rather settle for a passive fund. The passive fund would never beat the benchmark, but give similar returns i.e. not underperform grossly.

You should allocate to both as per your objectives, suitability and performance of the funds.

Should passives be part of core portfolio or satellite? There is a tendency to have passives in the satellite component as the core portfolio is expected to accumulate wealth over a long period of time via compounding effect. Since the fund manager needs a long time to outperform the benchmark, it should not be disturbed.

In the satellite portion, since you are taking relatively higher risk, you minimise the possibility of the fund underperforming the benchmark. Having said that, there is a shift, with a good reason, to have passives in the core component of your portfolio.

The portfolio allocation compounding and accumulating wealth over a long period of time should be defensive. That is, the risk of your exposures underperforming the benchmark should be low, as you do not want to go wrong on that part. The satellite portion is meant to bear the risk. If your call/the fund manager’s call goes right, you earn superior returns.

Conclusion

Data shows over 50% of active funds not beating the benchmark. The outcome varies on whether it considers direct plan (relatively lower expense ratio) or regular plan (relatively higher expense ratio). Hence, go for active funds where there is scope for the fund manager to outperform e.g. small cap or thematic funds. In large cap funds, the scope is limited as the universe is only 100 stocks. Where you want to settle for market or near-to-index returns, passives are better which can be core. Where you want higher returns, beating the index, you can allocate in the satellite component.

(The writer is a corporate trainer (financial markets) and author)