What price to reduce regret?

Active funds are sought after but passive funds make the cut

You should choose an active fund only if you are confident that the fund will generate positive alpha.  | Photo Credit: Maria Vonotna

Asset management companies are planning to unveil several passive products, indicated by the filings available on SEBI’s website. These products may be appropriate for an individual’s non-goal-based portfolio.

Your focus must be on large-cap index funds and ETFs for a goal-based portfolio. In this article, we look at the benefits and costs of investing in large-cap passive products.

Passive benefits

First, investments in large-cap passive funds are behaviourally optimal. You will regret even if an active fund you buy generates positive alpha (beats the benchmark index) but underperforms other active funds you did not choose.

You can reduce this regret by choosing, say, a Nifty ETF as all such funds will generate similar returns.

Second, the total expense ratio for a passive product is substantially lower than that of an active fund.

For instance, an ETF charges 5 basis points whereas an active fund could cost upwards of 1%. After accounting for brokerage commissions for buying the ETF, what you save in fees is available for investment through the time horizon for a life goal. Third, passive funds have only market risk whereas active funds have active risk in addition to market risk. That is, by investing in an active fund, you are exposed to risk of the fund underperforming the index. If your objective is to achieve a goal such as buying a house, then taking on market risk should suffice.

Total assets managed by active funds is more than that managed by passive funds. Clearly, active funds have a certain appeal among investors. Why?

For one, an active fund can give you greater returns than the benchmark index during a market uptrend and lower losses in a downturn. Passive funds will generate lower returns than the index during the uptrend and larger losses in a downturn because they do not generate positive alpha to compensate for the fees.

Open-end index funds also suffer from the cash-drag issue. That is, such funds are forced to hold cash to meet redemption requests from unit holders. Such cash is referred to as frictional cash. True, open-end active funds also suffer from the same issue. But such funds also tend to hold cash to time the market and generate higher returns. This cash is called tactical cash. Active funds can efficiently manage frictional and tactical cash to lower cash drag. Lower cash drag could improve fund returns.

Passive funds appear behaviourally optimal, yet active funds dominate the market. Because managers cannot consistently generate positive alpha, it becomes difficult to determine which active managers will outperform the index through the time horizon of your life goal!

Conclusion

You should choose an active fund only if you are confident that the fund will generate positive alpha.

You should then consider whether to carry such active investment beyond age 45. You are likely to cut equity investments to reduce the impact of a market crash closer to retirement. If you choose an active fund that underperforms the market closer to retirement, your losses will be greater.

Your default choice should be an ETF. Buying a passive product does not mean that fund managers cannot generate positive alpha. It means you are unwilling to accept the uncertainty in alpha generation. Settling for lower returns on ETFs is the price you pay to reduce the regret associated with investing in active funds.

(The author offers training programmes for individuals to manage their personal investments)