A mixed bag of active and passive investments to beat the volatility

Data from Amfi (The Association of Mutual Funds in India) for March 2020 shows an inflow of Rs 2,076 crore into index funds, which is marginally more than the inflow into large-cap funds. This indicates an interest in passive indexing strategies to the extent that that Index Fund NFOs are launching in this market too.

Take, for instance, the currently open Motilal Oswal S&P 500 Index fund or L&T Mutual Fund Nifty50 and Nifty Next50 NFO, which closed on March 31. Pratik Oswal, Head of Passive Funds, Motilal Oswal Asset Management Company, says, “Passive investing is more in alignment with simplicity. Today, index funds have become a lot more efficient in terms of how they are tracking their benchmarks.” Should you also go passive? Or should you stick to active funds especially in the current markets?

Why indexing: Simply put, you purchase a representative benchmark, such as the S&P BSE Sensex, Nifty 50 or an index like the S&P BSE Low Volatility Index. Koel Ghosh, Head of South Asia, Standard and Poor’s says, “The index is created through transparent rules, by independent index providers. There is no individual bias, or a fund manager bias in indexing as a strategy, unlike in active investing. It comes with the advantage of low-cost diversification; here, the single risk concentration is gone. The index is a formula cast in stone; if the market goes down, the index goes down, if it recovers, the index will recover, there are no surprises there.”

In a passive investment strategy, you maximise returns by minimising buying and selling. Two common ways to invest in equity markets is to either choose an index fund or an index ETF. The keep thing to remember here is that the objective of passive investing is to mirror the index and not beat the index.

How to invest: Gaurav Rastogi CEO, Kuvera.in says, “Index funds have low expense ratios, don’t carry any style or fund manager risk and need far less monitoring than active funds.” The asset allocation of an index fund tries to replicate that of an index but many times index funds have delivered slightly different returns than the index, due to tracking error. Tracking error is the standard deviation of the difference between the returns of an investment and its benchmark. Oswal says, “We have seen that over the long term, investors who make money usually do two things — make disciplined regular investments and keep costs low. Over the past few years, index fund expense ratios have gone down dramatically. make sense because they don’t underperform the index, and there’s never really a reason to churn them.” You can invest in a lump sum or go for systematic investment plans (SIPs) to buy units of index funds. Ghosh says, “In an index fund, you get the day-end NAV.” From a cost point of view, there is no transaction fee and no commission. Rastogi says, “Studies show that the fund expense ratio is inversely correlated to future fund performance, which works in an index fund’s favour.”

ETFs: Units of an ETF replicate an index like the Sensex or the Nifty. Each unit has the same weightage of stocks as the benchmark. Ghosh says “ETFs do have a lower cost than index funds, but you need a Demat account for an ETF.” The ETF is listed on the stock exchange; it is traded like a stock, hence it offers better liquidity. Though the returns of an ETF are usually close to that of the index, returns from different ETFs are different.

Rastogi says, “While both are good options, we would recommend Index mutual funds. This is simply because in volatile times, Index ETF can trade at a significant premium or discount to the underlying index, defeating the purpose of having index-linked investments. In March there were days when such ETFs were trading 6-7 per cent away from the underlying index, which we think is a big problem.”

Remember, the factor that affects the price of an ETF is the demand and supply for the security in the market. Oswal says, “Investing in ETFs is more suitable for a customer who is taking intraday calls. For a long-term investor, index funds make a lot more sense. They are a lot simpler.”

Active strategy: Active funds try to beat their benchmarks through careful stock selection, but charge a fee for this effort. Nimish Shah, Head of Investments, BNP Paribas Wealth Management, says, “Keeping in mind the inefficiency of the Indian markets with respect to those abroad, there are a lot of opportunities here that can be capitalised more by active management.”

You can take the help of wealth managers or financial planners to help pick the right funds. Shah says, “We can shortlist based on performance, risks and fund manager’s specialisation characteristics, looking for alpha.”

The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. Shah says, “Another thing to look into is risk-adjusted returns. Most of the good quality actively managed funds have a Standard Deviation lower than that of an index.” Many experts believe that active fund management is better positioned to do well in volatile markets.

Mixed bag: All experts we spoke to said that it always makes sense to have a mixed bag of active and Oswal says, “Having 20-40 per cent in makes sense, as that’s a core portfolio which an investor will never touch for 5, 10, 15 years. Then you can add on the satellite portfolio, with a bunch of active funds.”

There’s no debate between active or passive. The point is to take advantage of both strategies. Amit Jain, CEO & Co-Founder, Ashika Wealth Advisors, says, “The 2008 crisis was a financial crisis; this is a sovereign crisis for the developing world. It will have a far deeper impact on India. This started as a health crisis, moved to a financial crisis and can turn to a Geo-Political crisis. There is no single strategy you can rely on, so have a combination of both. It has to be across asset classes, using the right product categories at frequent intervals for the next seven months.” Jain has recommended his ultra HNI clients seven months’ staggered investments in equity savings funds, arbitrage funds and multi-cap funds.