Merits Of Including Passive Funds In Your Portfolio

There has been an ongoing debate about even though critics are of the view that a handful of best performing active funds always manage to beat passive funds, it is found that passive funds appear in almost every investors’ portfolio. On this aspect, we must acknowledge two critical factors -

1. Each active fund manager has a distinct investment strategy that is articulated in the scheme’s investment objective and laid out in the documents. Such a strategy finds favor in a particular market for a certain period.  
2. The top-performing funds will keep on rotating over time and tempt investors to bite. A lot of investors anchor on this past performance and keep adding a new set of funds every year. It is important to mention that past performance is not indicative of future returns. Such “return chasing” can often leave investors with average returns over long horizons.

Hence, comparing the best performing active funds versus their benchmark index funds serves only a limited purpose and should not be applied to choose active funds over passive funds. 

 How to select active schemes for investment?

 The first step should be to overlook the mirage of the top ten trending funds. A huge portfolio with “many” high performing schemes leads to false diversification and simply provides a misleading sense of security.

Instead, select active schemes based on these parameters: philosophy of the fund house, long-term track record, consistency of performance, credibility, and capability of the fund manager, and importantly, the scheme objective.

 When adding a scheme, make sure it fills the gap in your overall portfolio because,

• The new scheme is better than an existing scheme in terms of consistency of performance across evaluation parameters. If yes, then reduce exposure to the existing scheme and replace it with the new scheme keeping the frictions of exit load and capital gains taxation in mind. 

•  Gives you exposure to a segment that you were not a part of in your existing portfolio. Investing in this segment should fit in with the overall risk profile, investment horizon, and align your financial goals. 

 Index Fund

Many investors feel that all Index Funds (tracking the same benchmark) perform at the same level. After all, they are mirroring a common yardstick and have the same composition. While theoretically, it seems reasonable, the real picture is quite different. Index Funds with similar stock composition can have varied performance. Hence, it is important to consider the following factors while choosing between Index Funds.

1. Tracking Error

Tracking error is defined as the deviation between the returns generated by the benchmark and Index Fund. Several factors (operational costs, cash balance maintained for redemption, the time lag in rebalancing) contribute to this. 

 While this might seem like a complicated statistical metric, using the tracking error for decision making is less intricate. Simply choose an index fund that tracks the benchmark as closely as possible. Also, it is necessary to check not only the absolute value but also the trend or stability of the tracking error.

    2. Expense Ratio

The expense ratio is the AMC for your mutual funds. These charges eat out of your gross returns and hence should be kept as low as possible. Lower the expense ratio, better (or closer) the index fund’s capability in tracking the benchmark. In fact, in the long run, the sign of a good index fund would be its ability to restrict the tracking error to the quantum of expense ratio. 

 What not to expect?

    1.   Zero tracking error

If your definition of the best index fund means zero tracking error, you need to reconsider your expectations. Index Fund returns generally tend to lag behind the index that they are supposed to track.

     2.  Beat the market

Index Funds do not outperform the index. When they do, dig deeper as it may be temporary due to a lag in re-balancing. Either way, do not use index outperformance as a filter to select Index Funds. 

 So, now you know why the best active funds will outperform passive funds and yet why there is merit in including passive funds in your investment portfolio. 

 The author is Co-Founder and COO of Kuvera.in