Passive investing is picking up pace in developing markets. Passive Funds follow a strategy of tracking a particular index performance or a factor like quality, value, etc. In developed markets like US, passive funds currently account for 29 percent according to Moody’s.

Merits

The primary reason for rise in passive investing trend is cheaper way to earn an index return than it is to employ portfolio managers with the skills to outperform the index return. The second reason is performance by majority of the fund managers is very poor in beating the index even over longer periods.

In India as well, an active mutual fund costs 1-1.5% per annum in expense ratio versus an index fund that charges 0.1-0.3% per annum. Recent S&P SPIVA report indicates that only 37.22% active Large Cap funds have managed to beat Large Cap Index BSE 100 over a 10 year period. Also, only 50% of active Mid and Small cap funds have managed to beat BSE400 MidSmall Cap Index in same time period.

The reason for this underperformance is:

i) MFs AUM size has substantially increased as a % of free float Market capitalization to construct very different portfolio than the market;

ii) Expense ratio & turnover ratio (higher brokerage and impact costs) of MFs is very high which offsets excess returns generated by skill.

Demerits

Passive investment strategy selects stocks based on a particular criterion without any bias or insights from fund managers. This may lead to poor selection of stocks at times. Let’s take market weighted index for example, it invests more money in companies that are larger in size and less in smaller sized companies, irrespective of quality of the company or valuation of the company.

In bull markets, the pockets that are in bubble will have higher allocation and undervalued stocks will be pushed to much lower allocation. During correction, index can correct more and would take time to recover until these stocks are not moved out of index. This also means that index will take longer to recover from drawdown as opposed to Active Mutual Funds who will exit stocks based on their assessment. (Eg. Jan’08- Dec’13).

Over 3-5 years at bull market peak, most mutual funds may end up earning very similar returns to an index fund; however, some funds with portfolio of only quality stocks and lower turnover & expense ratio will tend to stand out over time. They will have lower time to recovery from drawdown, ability to dodge overvalued space and accounting frauds and outperform over longer time period of 10-15 years. The comfort of being invested in quality stocks handpicked by managers after intense research is more comforting to park large retirement corpus versus investing based passive strategy, even if it means a portfolio of quality stocks underperforms sometimes.

We like Index funds for low cost, simplicity and discipline. Someone without an advisor can certainly consider Index fund to be core part of one’s portfolio. Recently, DSP mutual fund has come up DSP Nifty 50 index Fund, DSP Nifty Next 50 index fund. They are charging just 0.2% p.a. and 0.3% p.a. respectively. There are many other index funds from ICICI, HDFC, SBI, etc. that offer such low cost Nifty & Sensex Index funds.

There are some interesting passive funds available in the market like DSP Equal Nifty 50 Fund, Edelweiss ETF Nifty Quality 30 and R*Shares NV20 ETF. They follow a different process than market cap weighted index and have potential to make higher plain vanilla index funds. However, they are recently launched hence difficult to review their performance; hence deserve only a small allocation.

Index ETF and index funds are similar except that Index ETFs require demat account and incur brokerage costs but can be sold in the market immediately to buy other stocks. Index funds are better than ETFs if one is investing for long term.

Select active mutual funds with passive fund-like characteristics of following a single process and maintaining discipline are better options than index funds but it’s not necessary that every investor would have a temperament to stick along with the fund through its underperformance. One needs advisor’s help to understand pros and cons of every process before shortlisting funds. Currently, we recommend 3-5 active mutual funds following different process and hold them tight for long term. In diversified process portfolio, 1-2 funds will keep outperforming which will help our clients ride out underperformance in others rather than moving in and out of underperforming funds incurring unnecessary Exit loads and Long Term Capital Tax.

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