In the current scenario should you move to Index funds, ETFs or, stick to active?

Most equity investors in the recent weeks would not have liked to look at their portfolios. This week the carnage looks worse. The Sensex is now down about 12% from its peak.

In the current uncertain market scenario due to the war in Ukraine, index investing might be looking increasingly attractive. This is especially important for those who intend to maintain their equity allocation. However they also want to cut down on the fluctuations they are willing to stomach.

At the same time, most smart long-term investors understand that there are hardly any options that can beat inflation in the long run apart from equity.

Index investing – numbers and context

There has been an increase in index funds and exchange-traded fund launches by AMCs in the last two to three years. Investors have also flocked to index funds with a gusto.

The popularity of index funds can be gauged by the fact that, according to a story in the Economic Times, the six-month average inflows in these funds has grown to Rs 3,582 Cr. The one-year average inflow last year was Rs 721 Cr.

Index funds have also seen an AUM growth of about 115% year on year between Jan ’21 and Jan ’22. This is the highest among all categories of equity funds. We need to keep in mind that this is on a much lower base compared to other categories.

A trend that goes deeper

The trend is seeing some depth as the new offers are based more on factor indices rather than just the simple market capitalization index.

With existing simple passive funds, active fund strategies and now many smart beta passive funds also available, you as an investor may be now spoilt for choice when it comes to the next incremental investment in mutual funds.

The question you have to ask yourself is whether adding a new fund type will achieve an objective that is unique.

Simple passive funds

Simple passive funds come in two types of wrappers, index funds and exchange-traded funds (ETF).

While the latter is more cost-effective, index funds offer greater flexibility for individual investors in terms of buying, selling and holding the units of such funds. Let’s assume, you are an existing investor in equity mutual funds and want to add index investing as part of your portfolio.

Then index funds would be less of a headache for you compared to ETFs. You’d have to first of all open a Demat account to invest in ETFs. Odds are that you already have one but logistically, index funds are simpler.

What matters in active funds? The fund manager for one

When you compare the viability of investing in a passive fund versus an active fund, the main difference comes to fund manager risk.

This is really the risk that your active fund manager has “low skills” and is unable to generate an excess return on a consistent basis when compared with the underlying benchmark of a scheme. This matters because you are paying an annual fund management fee.

Unless the scheme is able to deliver consistent outperformance against the benchmark, you may be better off investing in a low cost, simple passive fund which tracks the benchmark rather than paying hefty management fees.

However, do keep in mind that even the best fund managers will have periods of underperformance. This is especially true when entire markets are affected by a global event, like now.

In the domestic equity mutual fund space, the majority of the passive funds fall within the large-cap equity arena. Thus, the search has narrowed to choosing an active, large-cap equity fund that can do better than its passive counterparts.

There are roughly the same number of active large-cap funds which outperform passive funds in the space as compared to those which underperform when it comes to long term returns.

You want to be in the half which is outperforming and it’s best to seek the help of an advisor or a reliable investment platform while doing such a selection, from a limited set.

Factor-based passive funds

These are the more recently sought after and popular forms of passive equity funds. More popularly known as smart beta funds, such passive funds invest in a portfolio that mirrors secondary indices that apply factor-based filters to curate portfolios.

There are around 16 such funds in India as of October 2021, commanding a total of Rs 2,500 in AUM as per an article on moneycontrol.

The factors can be technical or fundamental in nature and help in narrowing down a stock set based on some typical qualities.

In form, they are similar to active funds because some of these factors are used by fund managers for stock selection too. Smart-beta funds, as they are known, are more an option rather than a necessity in your investment portfolio.

Allocating small amounts may work in giving you a better understanding, but there is no visibly, unique advantage in adding high proportion of such schemes to your portfolio.

If your equity portfolio is say worth Rs 75 lakhs, maybe a percentage or two in such funds is the maximum you should consider. You should also know that there is no provable and significant benefit in having such funds in your portfolio yet, based on the research that’s present.

Keep in mind that hardly any advisor would recommend you go for these kinds of specialist funds if you don’t have your basic allocation to the core classes in place. By that we mean – large caps, diversified funds, and may be mid cap funds in your overall equity allocation.

The final word

The lure for passive funds really lies in the cost-effectiveness and inability to navigate fund manager risk if you are doing all of it yourself.

If you have a good advisor in place, there are active funds in the market which offer a significant alpha or excess return over passive schemes, net of cost.

Your choice of active over passive will be determined by your access to a good advisor and research. Fund selection is an important aspect which contributes to the long-term growth outcome of your equity portfolio. Hence, think it through before making the choice.