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Passive Mutual Funds

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Opting for index funds and ETFs will make investing simpler and cost-effective, while earning you benchmark-equivalent returns





The Advantages


Suited to efficient markets: Globally, it has been witnessed that as markets become more efficient, it becomes harder for fund managers to beat their benchmarks. Passive funds progressively become the preferred investment vehicle in such markets.


In the Indian market's most efficient segment, the large-cap space (funds with more than 80% allocation to large-cap stocks), passive funds have a significant presence. The category has 45 active funds (only primary funds included) and 30 passive ones. Their proliferation indicates that fund houses are preparing for the day when investor preference might shift to passive funds.


Low expense ratio: The prime attraction of passive funds is in their low cost. In recent times, while expense ratios have fallen in the passive fund space, they have risen in active funds. The most inexpensive index fund and ETF both have an expense ratio of 25 basis points. The median expense ratio for ETFs is 59 basis points, and for index funds, 1.5%. In comparison, the minimum expense ratio for actively managed funds is 1.25% (Quantum's fund). The maximum is 3.13% and the median is 2.45%.


At the starting line each year (returns are calculated after deducting expense ratio), ETFs have an advantage of 1.86 percentage points, and index funds, 95 basis points (comparing medians), vis-à-vis active funds. According to Morningstar US, the best predictor of performance is not past return or star ratings, but low expense ratio.


Automatic clean-up of portfolio: Due to the manner in which indices are constituted, an automatic clean-up of portfolio takes place in passive funds. These indices own the outperformers and remove the underperformers. Indices keep changing since yesterday's blue chips may no longer be so today. When people opt for passive funds, they don't need to worry about being invested in laggards.


No security-specific risk: Security-specific risk gets reduced as a single stock or bond has a limited exposure in an index and can cause only limited damage.


Easier to manage portfolio: Investors don't have to bother about the performance of specific funds. All they have to do is rebalance their portfolios.


The Disadvantages


No outperformance:
A small set of active fund managers will always outperform the indices. Passive investors shouldn't pay too much attention to the active funds that have outperformed in a given year. Remember that the probability of correctly predicting next year's winners year after year is very small.


Lack of options: Today there aren't enough passive funds for executing all types of investment strategies. For instance, there is only one mid-cap ETF (from Motilal Oswal AMC). On the debt side, there is a severe lack of options (only 10-year Gsec funds are available). In the international space, while you have a fund based on the NASDAQ, a passive fund based on the US S&P 500 Index is not yet available. The overwhelming majority of funds is based on the Nifty and the Sensex. Clearly, many more types of passive funds need to be launched in India.


SHOULD YOU OPT FOR THEM?
Earlier considered the domain of conservative investors, passive funds are now finding a place in all retail portfolios. The significant alpha that fund managers used to generate in the past is becoming harder to achieve. It is difficult to tell whether this is a long- or short-term trend. However, investors need to hedge their bets by including passive funds in their portfolios.


Begin with a 20% exposure to passive funds and gradually raise it to 50%, or higher, if the trend of fund managers failing to beat their benchmarks becomes more pronounced in the future.


Choosing The Right Funds


To select the right passive fund, consider three criteria: low tracking error, low expense ratio and adequate AUM. You could give a 75% weightage to tracking error and 25% to expense ratio. The tracking error is a much more significant criterion. If it is low, it allows one to select passive funds whose returns are predictably close to the returns of the benchmark. It is such predictability that one seeks in a passive fund.


One dilemma that you are likely to face in selection is that many funds with low tracking errors and low expense ratios have low AUMs, which carries certain risks. The fund may not get the desired attention (even a passive fund needs to be rebalanced). Besides, if the AUM does not rise in a few years, the fund house may decide to merge or close the fund. When this happens, it could create tax liability. To avoid these risks, you should opt for a fund that has an AUM of at least 100 crore.


If you want investing to be devoid of complication, it will be a good idea to stick to index funds and exchange traded funds.

Happy Investing!!

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