scorecardresearchAmid market volatility, how to rebalance portfolio between active and passive

Amid market volatility, how to rebalance portfolio between active and passive funds

Updated: 24 Aug 2022, 01:23 PM IST

Portfolio management in a volatile market inevitably has to address the classic question around Active and Passive funds.

Active vs Passive Funds

Active vs Passive Funds

After a fairly strong run in the post-Covid world, markets took a breather. While most of us were long expecting a slowdown in the pace of the market rally, the past few months have been a rather topsy turvy journey for everyone’s portfolios. If not for some much-needed relief rally in the past month, investors were starting to get wary of the pitfalls of volatility, stagflation and global slowdown.

 Despite this recent recovery, market participants remain cognisant that this might not sustain immediately and there may be further volatility to come in the near future. Especially if developments around the trinity of inflation, growth and monetary policy do not play out in line with expectations.

 Given this backdrop, it would be a good time for investors to review their portfolios and look for realignment to brace for the volatility or prepare for the next longer market cycle.

 Portfolio management in a volatile market inevitably has to address the classic question around Active and Passive funds. On the one hand, there is the argument that active funds provide the flexibility for fund managers to pick ‘quality’ stocks while avoiding stocks or sectors which would underperform in a volatile environment.

Hence the view that active fund management is even more relevant in the current market environment, in its role of being able to actively adjust the portfolios to take advantage of changes in market dynamics.

 Passive funds, on the other hand, are seen as delivering close to market returns without the risk of human bias or going wrong with stock picking. In India, passive investing through mutual funds has picked up pace in recent years. At over Rs 5 lakh crore AUM size, this accounts for more than 12% of the Rs 37 lakh crore industry pie.

While a large part of the passive fund inflows today come from the Employees’ Provident Fund Organisation (EPFO) investing in ETFs based on Nifty 50, Sensex, CPSEs and Bharat 22 indices, cost-conscious investors are also joining the bandwagon of late. This is due to the diminishing alpha in certain segments. In terms of asset classes, passive products investing in equities hog the limelight, while ETFs dominate the space when seen from a product structure perspective.

 In our opinion, while both are valid arguments. Basically, it is a case of oversimplification of the allocation decision by simply looking at the 2 categories without digging deeper in them. The ideal way to realign the portfolio would be to orient it towards defensive or less volatile strategies which aim to protect on the downside.

This can be seen in quantitative as well as qualitative research. While qualitative research helps in understanding the investment objectives of various managers or strategies and categorise them in terms of their style, quantitative data helps in validating their performance. In terms of risk management, we can use data points like beta, downside capture, standard deviation and historical drawdowns.

Using the understanding from such analysis, investors can get deeper insights into each of the Active and Passive fund categories. To take a simple example within the passive funds basket, we look at Nifty Index, Low Volatility Index and Quality Index. The annualised volatility over the past 10 years has been 17%, 13% and 14.5% respectively, suggesting that Low Volatility and Quality are both expected to do better than Nifty in the passive fund category when markets are volatile.

Similar exercises with more data points and funds can be undertaken to identify the strategies which are better placed to perform well and create an optimum mix to navigate the portfolio in a volatile environment.

Vivek Goel, Co-founder and Joint Managing Director, Tailwind Financial Services, a new edge wealth management platform.

These are the differences between active and passive fund management.
First Published: 24 Aug 2022, 01:23 PM IST