Ask Morningstar: A portfolio of passive funds

By Mohasin Athanikar |  05-07-22 | 

Whenever markets down, I add DSP Nifty 50 equal weight fund and Sundaram Nifty 100 equal weight fund. I would like to choose between Kotak Nifty NV20 ETF and NIFTY 50 ETF. How must I decide? What factors must I consider when looking at ETFs?

I have decided to answer your query in a broad way as I have no clue concerning the rest of your equity portfolio.

Understanding the difference between active and passive.

Index funds and Exchange Traded Funds (ETFs) are passively managed funds that track an index. What this means is that the fund aims to invest in the same securities as that in the index and in the exact same proportion. The fund manager has no say in security selection, his task is to mirror the underlying index.

In an actively managed fund, the fund manager invests in select securities which he expects to outperform the benchmark. Investors opt for passive funds only if they believe that active managers cannot outperform the benchmark after expenses. Over the past few years, most fund managers, particularly in the large-cap segment, have found it difficult to beat the benchmark. This is one of the reasons passive funds have witnessed an increased interest in recent years. 

What to be aware of.

Compared to actively managed funds, index funds/ETFs charge significantly lower expense ratios.

Be mindful of the risks of investing in passive funds such as security/sectoral concentration risks. In the case of equities, if the underlying index has no cap on security level weights, the index fund / ETF may turn out to have a high concentration to select securities, which exposes the portfolio to company-specific risks. Unlike actively managed funds, managers of index funds cannot protect the downside by moving away from the sector/security in case the outlook for the same deteriorates as they are mandated to mirror the index.

Equal weighted funds such as the ones you mentioned invest equal amounts (rupee terms) in all securities which are a part of the index, in contrast to the typical market-cap-weighted fund (such as Nifty 50) which invests a higher proportion in a few securities weighted based on the free-float market cap of underlying holdings. Such funds thus provide higher exposure to smaller holdings vis-à-vis the market-cap-weighted funds and hence investors betting on a broader market rally (particularly in the relatively smaller holdings) invest in such funds.

Nifty NV 20 Index tracks the performance of 20 ‘value’ companies that are part of the Nifty 50 index. The value companies are defined as companies with low P/E (price-to-earnings), P/B (price-to-earnings), high D/Y (dividend yield) and high ROCE (return on capital employed). The index provides exposure to the value style of investing and helps investors diversify the overall style (value vs growth split) of the portfolio.

Once an index fund /ETF has been decided upon for inclusion in a portfolio, you could consider the tracking error and expense ratio (lower the better) of the funds within a peer group. Also, in the case of ETFs one should consider the liquidity available on the stock exchange since low liquidity can negatively impact returns if investors are forced to trade at adverse prices.

Having a portfolio that combines both.

Active or Passive: Which is better? The answer will depend on who you ask.

Neither approach is superior. You could opt for only passive funds, or only actively managed funds, or an optimal combination of both.

We believe that asset allocation is one of the most important decisions that you make as an investor. Having the right mix of equity, debt, cash and commodities in your portfolio can have a profound impact on your returns. Within asset classes too, diversification should take place between sectors and style (value/growth) for equities, and credit quality and duration split when it comes to debt.

One could consider investing with a mix of both active and passive funds which would provide the best of both - an opportunity to capitalize on opportunities via active management and limit overall portfolio costs.

Having said that, in India, the options are still limited. Only domestic equities have index funds or ETFs representing different market segments (large/mid/small caps) as well as the broader market. Passive international equity exposure is offered by a handful of funds, most of which are U.S. focused. There are a few India domiciled passive funds offering fixed-income exposure in India, such as Liquid ETFs, 10-year gilt ETFs, and the Bharat Bond ETF which invest primarily into AAA-rated PSU entities and G-secs and have a run-down maturity restricting investors from selecting a target duration.


Articles authored by MOHASIN ATHANIKAR

Registered readers can post their queries by accessing the Ask Morningstar tab. Our team will answer SELECT queries relating to mutual funds, portfolio planning and personal finance. While we provide broad guidelines, we suggest you consult a financial adviser before making investment decisions.

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