Passive investing has revolutionized portfolio management by offering simplicity, diversification, and cost-effectiveness. In this blog, we delve into the construction of a portfolio using passive funds.
Passive investing has revolutionized portfolio management by offering simplicity, diversification, and cost-effectiveness. In this blog, we delve into the construction of a portfolio using passive funds. At the end of December 2023, the global passive equity funds AUM stood at $15.1 trillion against $14.3 trillion of active funds.
Passive investing is a buy-and-hold strategy where you try to match the performance of an index. This is a cost-effective strategy as it doesn’t involve professionals who analyze opportunities and act accordingly. Here, one is betting on the market to move upwards in the long term. These are some advantages of passive investing.
Index funds and ETFs are two primary vehicles of passive investing. Index funds are mutual funds that aim to replicate the performance of a specific market index, while ETFs are traded on exchanges like stocks.
While outperforming the benchmark during bull phases is tough, active management comes in handy during bear phases. Large-cap, mid-cap and small-cap funds performed better in the majority of bear phases since 2000. Think about it, in a sector-heavy index like NIFTY 100, the collapse of one of the highest-weighed sectors can drag the index. By prudent stock selection, active managers can reduce the impact on the mutual fund portfolio.
A CRISIL Research for the period between April 2010 and March 2021 reveals a longer holding period improved the chances of generating alpha returns. The average underperformance across categories reduced from 31% for a one-year investment horizon to 3% for a five-year investment horizon.
Source: crisil.com
The performance during a single cycle should not be considered for evaluating the performance. As funds go through economic cycles, the performance varies and through longer horizons, the efficacy of the funds can be evaluated. Fittingly, in a move to avoid any mis-selling AMFI has directed the fund houses to showcase only 10-year rolling returns in the advertisements.
In generating alpha, funds across all categories show huge dispersion. Across categories, the difference between the best and the worst-performing funds is huge. This stresses the need for prudent financial advice when choosing funds.
An investment portfolio should be a mix of both styles – passive funds to ensure capital protection and active funds to ensure higher returns in the longer run.
Again, it is difficult to suggest a one size fits for all break up of both styles. Ideally, someone who is risk averse and has a shorter investment horizon should look at portfolio protection and must have a higher concentration of passive assets. Whereas someone who is more risk-taking and has a longer investment horizon should look at adding more active assets.
Adopting a core-satellite portfolio approach would help to optimize costs, tax liability and volatility. The core portfolio will include the passively managed funds, which would reduce costs and volatility and the satellite portfolio would ensure maximum return.
Core portfolio – Index funds or ETFs tracking broad market indices like NIFTY 50, NIFTY Mid cap 100, NIFTY Small cap 100, etc.
Satellite Portfolio – Active Mutual Funds, PMS, AIFS, sector specific funds, quantitative strategies like momentum or value, etc.
A balanced portfolio will have 50:50 exposure to both strategies.
Constructing a solid investment portfolio is crucial for securing a prosperous future. Each individual's portfolio goals differ based on their risk tolerance, underscoring the importance of discerning between various strategies to enhance portfolio growth. Seeking sound financial guidance, when necessary, is advisable to navigate the noise and make informed investment decisions.
