The year 2022 saw a number of new products emerge in both the equity and debt mutual fund space. These products stand out for the following distinct features — low cost and reduced need to manage portfolio. They are passive funds — ETFs and index funds.
Passive investing, both through ETFs and index funds, has been very slowly gaining ground. But fund houses are clearly anticipating a big shift. The number of passive fund launches in 2022 (read this article http://bit.ly/3Wvowty) suggests AMCs don’t want to miss out on the transition, when it gains momentum.
Need for passive funds
You need passive equity funds as part of your portfolio for several reasons. In the past 3-5 years, funds, especially large cap and multi-cap funds have found it increasingly hard to beat their benchmarks.
Fewer funds beat the index now than a few years ago. Just to illustrate, in 2017 — based on rolling 3-year returns then, almost 8 in 10 large-cap funds beat large-cap benchmarks such as the Nifty 50 or Nifty 100. This has reduced to just 3-4 funds in 10 beating the benchmark now. That means the chance that a large-cap fund you hold will consistently beat the benchmark is below 50%.
When you add a simple index fund, you can at least be sure you are sailing with the market. So, the question of whether your fund is underperforming, or outperforming will not arise. And here’s more.
As passive funds mimic an index and have no active fund management, they do not carry hefty expense ratios. This cuts the cost and adds to returns. A few years ago, outside of ETFs/index funds based on the Nifty 50, there were little options to build a diversified equity portfolio with passive funds. It has now changed.
Different market cap
Passive funds come with different market cap categories now — Nifty 50 (large cap), Nifty 500 (multi cap), Nifty Midcap 150, Nifty Small Cap 250 and so on. That means you can actually build a portfolio with different market-cap segments like you would, with an active portfolio.
And then there are strategy-based passive funds or factor investing as they are called — such as value, alpha, low volatility, equal weight, momentum and so on. That means just as you would have a value fund and a growth fund, you would be able to mix different strategies in the passive investment space as well. Of course, strategies can fail but that would be because of the market and not poor fund management.
And finally, there are also thematic funds – those that invest in international ETFs and also in local sectors and themes. Most ETFs earlier suffered from low turnover in the stock exchanges and this was a big drawback for retail participation. The good news is that this is changing with volumes improving well for major market-cap indices and a good number of factor indices as well.
And, even if you do not want to buy ETFs (as they need a brokerage account), there are enough options in the index fund space that you can invest in today. To top it, there are Fund of Fund options that allow you to participate in ETFs through the regular fund route.
And passive investing is not restricted to equity. After a series of disastrous events in the debt space between 2018-20, the past two years have seen several fund houses come up with open-ended passive debt funds with a maturity date (called target maturity funds) and with high quality papers.
These can either be bought in exchange (ETF) or invested in like any other fund (Fund-of-Fund route or index funds).
Most of these come with maturity dates across various time frames and hold either PSU bonds or Central and State loan bonds, making them low risk products. They carry low credit risk and do not suffer from risk of fund manager getting it wrong.
As debt fund returns are themselves in single digits, expense ratio can eat into returns. Passive funds give the advantage of low cost and eat less into returns.
If you do not have a passive equity fund, start by adding a large-cap index fund or large and mid, or the 500 index slowly along with existing active funds.
With debt, this may be a good time to lock into high yields with target maturity funds. When you clean up your portfolio, try replacing some exits with passive funds.
(The writer is co-founder, Primeinvestor.in)