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Should you become active in passive funds?

Whenever stock markets have a narrow rally, where five-to-six stocks drive the performance, active funds see a dip in returns

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Many of us have seen YouTube videos of football stars Messi and Ronaldo finding it difficult to put the ball past the robot goal-keeper. With its stretched metallic hands and razor-sharp reflexes, the robot goal-keeper manages to stop the ball quite a few times before the famed scorers finally manages to get one in.

A similar situation seems to be emerging in the large-cap funds space. In the overall large-cap fund category, passive products, such as Exchange Traded Funds (ETF) and index funds, have been the top performers in the last few months.

In fact, year-to-date, no actively managed large-cap equity offering has managed to beat the Sensex's 12% rise. Even mutual fund houses are getting active on the passive space. Fund houses They have filed a total of eight new index and ETF offerings in the past three months, indicating a renewed interest. According to experts that DNA Money spoke to, it may be time to get serious on the passive space in large-cap funds, while still having your core portfolio around actively managed schemes.

What is active and passive

First, let us look at what the terms 'active' and 'passive' funds mean. In an actively managed fund, fund managers use their expertise and bias to choose stocks. They aim to beat the market, leading to higher cost of fund management (100-125 basis point cost). In passively managed funds, the fund tracks an already existing index and aims to replicate market returns. The passive funds have a lower cost (5-50 basis point cost). Actively managed mutual funds in India have, so far, built a great track record. Hence, some fund managers have a cult following comparable to rockstars.

However, as recent figures show, the halo enjoyed by actively managed funds may be fading. There is a combination of reasons why actively managed large-cap funds are finding difficult to deliver an excess return over a benchmark, say Nifty or Sensex. One reason could be that Indian stock markets are slowly becoming more efficient and top stocks (large-cap shares are the top 100) are subject to intensive research.

New passive funds in the offing

Many large domestic investors are more passive-investing oriented. The EPFO started investing in exchange-traded funds in August 2015. It invested 5% of its investible deposits in 2015-16, 10% in 2016-17 and 15% in 2017-18. It is estimated that it has invested over Rs 47,000 crore in total and has seen double-digit returns. So far, it has concentrated on Sensex ETF and Nifty ETF. But in the near future, EPFO may diversify into more ETF types. In last few months, fund-houses have filed new fund offerings for Motilal Oswal Nifty 250 Index Fund, Mirae Asset Nifty 50 ETF, Tata Nifty Exchange Traded Fund, SBI–ETF Quality, HDFC Low Volatility ETF, Reliance Junior BeES FoF, ICICI Prudential Nifty Next 50 ETF and Reliance ETF Nifty Midcap 150. Whether this will push up activity in the ETF space, thereby making it more conducive to retail investors, is to be seen.

Advantage of passive funds

"Actively managed funds have for long out-performed index funds and ETFs. There is a reason for that. Firstly, markets are still not that efficient; as a result, fund managers are still able to identify mispricing opportunities and exploit them. Secondly, earlier actively managed funds were able to out-perform in the price-return form; with total returns coming into the picture, that is including dividends, out-performance is slightly more difficult. As Indian markets become efficient, index funds and ETFs will perform very well," said Suresh Sadagopan, Founder Ladder7 Financial Advisories.

Some feel the out-performance seen in actively managed funds will slowly narrow. "10% of money can definitely go into index funds and ETFs. This will change dramatically going forward in maybe 1-2 years (more money to be in passive funds)," added Sadagopan.

The SPIVA scorecard (S&P Indices Versus Active Funds) shows more than 50 per cent of the active fund managers are getting beaten by the benchmark. "Do remember that consistency in delivering above average returns is not easy given churn in fund managers and continuous marlet dynamics. Passive investing is a growing space that merits inclusion in investment strategies. It is no longer a choice of either or," said Koel Ghosh, business head (India), S&P BSE Indices.

Whenever stock markets have a narrow rally, where five-six stocks actually drive the performance, actively managed funds tend to flounder more. If a handful of stocks, like this time around TCS (up 70% in 1 year), Infosys (up 63%), RIL (up 54%), M&M (up 40%), and HUL (up 38%) etc, go up and pull the market along with it, the absence of those stocks in a portfolio does hurt. Radhika Gupta, CEO, Edelweiss Mutual Fund admits that large-cap fund returns definitely have to come down with the new Sebi categorisation rules and that is in line with global markets. "Funds have become larger and these stocks are also better covered. Last year was a little more exaggerated in my view because the benchmark gains have been driven by five to seven 5-7 names, so if a fund didn't hold them it would have trailed. I still believe a process driven active fund run at low costs can add value in the large cap space, maybe 2-3% over benchmarks," said Gupta.

Index funds and ETFs have inherent advantages. Renu Pothen, research head, fundsupermart.com explains that index funds or ETFs are not actively managed like other funds, and replicate an index like S&P BSE Sensex, Nifty or S&P BSE 500.

"Although they are as volatile as the index they mimic, they are considered to be less risky than other funds, and are also a far cheaper option. Investors who are content with earning market returns can opt for ETFs and stay invested in them over the long term," Pothen said.

They can also be used to complement actively managed funds in an investor's overall portfolio to balance volatility and cost, while still retaining the equity flavor.

Where active funds score

However, according to Amar Pandit, founder, HappynessFactory.in, passive funds may not be the best bet for Indian investors. "Passive funds are not suitable for developing nations like India, where majority of funds are able to outperform its benchmark by at least 4-5% p.a. By investing in diversified equity funds over index funds, long-term investors can make substantially higher returns. This applies to large-cap ETFs as well, with the only exception being that we need to have a demat account to hold it and it is traded on the exchange. Hence, this is one more disadvantage of large-cap ETFs compared to index funds," he said.

Also, liquidity could be a practical problem for ETFs when you go to buy or sell. Often, investors have seen the price of an ETF drops sharply as they try to liquidate more and more of their ETF units. The additional cost and the hassle of not finding enough buyers can be a hindrance. You can be stuck with an illiquid ETF and would be forced to contact the fund-house to help you redeem them.

BEING PASSIVE HELPS AT TIMES

Rs 47,000 crore 
Amount invested by EPFO in ETFs since 2015

100-125 bps 
Cost of active funds

5-50 bps 
Cost of passive funds

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