Blend of active and passive funds works

Last one and a half year have been quite challenging for equity investors. Although the benchmark indices touched an all-time high after the BJP led NDA swept through most parts of the country in the general elections, many investors are disappointed as their equity mutual fund portfolios have not kept pace with the market. This happened mainly because only a handful of large-cap stocks drove headline indices northward and mid and small-cap stocks bucked the market trend. 

The narrow market breadth allowed certain categories of passively managed large-cap and large-cap oriented funds such as Index as well as Exchange Traded Funds (ETFs) to outperform actively managed funds with a similar investment universe. For example, while ETFs based on NV 20 index topped the performance chart, Nifty Next 50 ETFs/index funds underperformed the active funds. The current situation has created a dilemma in the minds of investors about the composition of their portfolios. 

The main question, therefore, is whether passive funds should be a part of every investor's portfolio and, if yes, which ones and in what proportion. Let's begin by understanding more about passive funds and how these are different from actively managed funds. 

An index fund is a type of passively managed fund that seeks to track the performance of a benchmark market index such as BSE Sensex or S&P CNX Nifty. To achieve this intended result, the fund maintains the portfolio of all the securities in the same proportion as in the benchmark index. While this ensures that there are no surprises in terms of composition of the portfolio, the downside is that one forfeits the possibilities of earning above average returns that a good quality actively managed fund may be able to do over the longer term. 

The ability to move in and move out gives an active fund manager an advantage over a passively managed fund. Considering that index funds are effectively run by the computers and the fact that price sensitive information keep appearing regularly, actively managed funds have the potential to provide superior returns over the longer term. 

ETFs are essentially Index funds that are listed and traded on an exchange such as stocks. To buy them, one must have a demat account as well as a trading account with a broker/sub-broker. Like index funds, ETFs also allow long-term investors to diversify their portfolio at one shot and at a lower cost than actively managed funds. ETFs usually score over index funds in terms of lower tracking error and higher efficiency as they allow investors an opportunity to buy/sell any time during the trading hours. 

As is evident, there are pros and cons of investing in both actively managed as well as passively managed funds. While the exposure to these two categories of funds should ideally be in line with an investor's time horizon, risk profile, size of the portfolio and the understanding of how different segments of the market behave over time, as a thumb rule the portfolio can be indexed to the extent of 15-20%. Clearly, short-term performance trends shouldn't be the basis of including or increasing exposure to a particular type of fund. 

New investors should begin investing primarily in large-cap oriented ETFs such as Nifty 50 and Sensex. For investors looking to invest in multi-cap as well as mid and small-cap funds, actively managed funds would be a better bet as fund manager's expertise and investment philosophy can generate alpha over time.

Therefore, investing in a blend of active and passive funds can be a good strategy. Remember, to benefit from the true potential of actively managed funds, one must choose funds well and give them sufficient time to perform. Similarly, before investing money in a passively managed fund, one must be careful about the selection of the index.

The writer is CEO, Wiseinvest Advisors