Should you invest only in passive index funds? Or should you invest in active equity funds? While proponents of both active and passive will have their arguments to attract investors, I think it is better to have an allocation to both in the equity funds portfolio.
In active funds, while there is the potential of outperforming the index, there is also the risk of underperforming it. While in passive, the idea is to mimic the index returns (after tracking error, etc.) so you neither try to beat the markets nor you ever have to underperform the markets.
So how exactly should you mix active funds and passive funds in your equity funds portfolio?
Let’s try to understand the problems first and then find the solution.
If you consider the data of the last several years, it’s clear that a majority of schemes in the active large-cap fund space are finding it difficult to continuously outperform the index on a rolling-return basis. The local reasons can be many but this is a global trend as well. So, for those who are in markets for long, this isn’t surprising.
And due to this sustained underperformance and not having dependable and consistent largecap outperformers, many investors feel that active large cap funds do not justify the high expenses they charge. As a result, these investors are slowly gravitating towards passive large-cap index funds.
On the other hand, in mid and smallcap space, the markets are still less efficient and the information available is also less reliable. As a result, there is potential for outperforming the index if the fund manager is capable. And this mid-small cap space is where good active intervention can be the key to good index-beating performances.
Unlike large cap funds where most are unable to beat the index, there are still many good active mid and smallcap funds that are doing better than their respective index benchmarks consistently.
There is no ideal combination of active and passive funds in a portfolio. But in my view, combining the above two observations, opting for the passive strategy where it is difficult to beat the index is the way to go. And in market segments where the higher expenses of active funds justify the potential for higher alpha and outperformance, it is better to go for active funds.
So here is what can be done by investors –
- For getting large cap exposure in a portfolio, it’s best to go for passive large-cap index funds based on Nifty50 or Sensex. One can even consider Nifty-Next50 based index funds, though its characteristics are more like midcaps than large caps where it is generally bucketed as per SEBI guidelines.
- For giving midcap exposure to your portfolio, you can go for good active midcap funds with proven track records.
- Most investors don’t need standalone smallcap funds but if you still want to have, then active is the way to go here given the information asymmetry and alpha potential. So here also, look for well-proven active smallcap funds.
- One can also consider going for active fund categories like Flexi cap funds and Large & Midcap funds that give retail-efficient allocation to mid and small cap funds and simply skip pure mid and small cap funds.
What about sectoral or thematic funds? You don’t need them. Surprised? To know more details, read this.
What about international allocation in equity portfolios? Once your Indian allocation is set and your portfolio size grows to a reasonable level, you can take exposure to international markets (mostly developed economies) via the passive route. Examples can be index funds/ETFs based on Nasdaq100, S&P500, etc.
While having a passive-only or active-only strategy isn’t wrong per se, from what we know about the recent performance history of all categories, it’s best to combine the two approaches for a more optimum mix of investment strategies across different market cap spectrum.
With the growing maturity of different segments of the Indian stock markets, generating alpha for active fund managers on a continuous basis in many categories will be a challenge going forward.
But for the time being, having a good mix of active and passive strategies is expected to work for the next several years. If you have doubts about what is the right mix for you and your goals, then please get in touch with an investment advisor.
Dev Ashish is a SEBI-Registered Investment Advisor and Founder (Stable Investor). He provides fee-only financial planning and investment advisory services to small and HNI clients across India.