Mutual funds: Time to go partially passive?

Updated : May 11, 2018 14:15:56 IST

Active versus passive is actually the hottest debate in the personal finance sphere in India at the moment.

A passive fund simply mirrors an underlying index.

At the outset let me start by clarifying- no this is not a throwback to grammar class, nor is this a piece on linguistics.

Active versus passive is actually the hottest debate in the personal finance sphere in India at the moment.

We’re talking money, your money invested in mutual funds for a long period of time. Which is why along with expectations of compounding returns, the question of compounding costs becomes extremely relevant.

First things first, let’s get to the basics specially for new investors who may not be familiar with the difference between these two forms of investing.

UNDERSTANDING PASSIVE AND ACTIVE INVESTING

Active investment, as the name suggests, involves active management of money. Here a fund manager uses his or her intellect to select a portfolio of stocks he/she believes will generate good returns.

The discretion of what to keep in and what to weed out lies with this individual who is hands on with managing the fund. Passive investment, on the other hand, involves no such human judgement.

A passive fund simply mirrors an underlying index. It has the same set of stock as its benchmark (though the proportionate contribution from these stocks may vary – we will discuss this a bit later).

PASSIVE FUNDS: SIZE DOES MATTER

The lion’s share of mutual funds in India fall in the ‘active’ category. Passive investing is still new to us. Out of the Rs 23 lakh crore total assets managed by the Indian mutual fund industry, just about Rs 82,000 crore lie with passive funds.

Contrast this with a highly developed market like the United States, which saw a massive surge of money into passives in calendar year 2017.

According to Morningstar data, passive funds saw a staggering, record inflow of $693 billion dollars last year while active funds saw an outflow of $7 billion. 2017 was the third consecutive year when passive funds in the US drew in big money and active funds actually saw net outflows.

SO WHY GO PASSIVE?

Coming back home and back to the central question – why should one consider investing in passive funds? The simple answer – because they are far cheaper than active funds and thus very relevant when an active fund is not able to generate significant ‘alpha’ or outperformance over its benchmark.

In one line, it boils down to how much are you paying as the fund management fee and how much return are you actually getting for that money?

TYPES OF PASSIVE FUNDS

Passive funds are of two types – ETFs or exchange traded funds and Index Funds. The former trades on the exchange just like a stock – you can buy and sell as many units as you want and prices keep changing through the day like any listed share.

The latter is like a regular mutual fund where the stock composition will be exactly similar to an underlying index. For example the ICICI Pru Nifty Index fund comprises of a basket of the 50 stocks that make up the NSE Nifty 50 index. However its important to note that all index funds may not be exactly identical to the underlying index.

Take the example of the DSP BlackRock Equal Nifty 50 fund. This index fund comprises of all the Nifty 50 stocks but ascribes ‘equal weights’ to them instead of the weights followed by the underlying index. This means that unlike the Nifty which is more skewed towards some sectors like banking, an equal weighted index fund sees equal contribution from all stocks of the index.

The asset manager offering this particular fund claims the equal weight strategy generates higher return over longer time periods than a pure vanilla simply Nifty fund.

ACTIVE VS PASSIVE FUNDS: THE COST FACTOR

Now let’s move to the important issue of cost. The biggest thing working in favour of passive funds is their low expense ratio. The expense ratio of ETFs can be as little as 5-10 basis points i.e just 0.05 to 0.1%.

Compare that with the 2.25- 2.5% fee that active mutual funds charge and you will understand why this debate is so relevant. The total cost of investing via an ETF however is slightly more than what the expense ratio suggests.

“You have to add up the brokerage fee and demat charges to the expense ratio. Which means the total cost comes to about 40 basis points or 0.4%” explains Anil Ghelani, Senior VP at DSP BlackRock Mutual Fund.

The cost of investing via an index fund on the other hand ranges between 40-90 basis points.

To sum it up – passive funds charge you less than 1% as management fee while active funds charge up to 2.5% to manage your money. Which is why you’d want them to deliver higher returns than passives, right?

This brings us to the heart of the active vs passive investment debate.

ACTIVE VS PASSIVE: RETURN ANALYSIS

As an equity market matures and information on listed companies becomes more easily and widely available, it becomes that much harder to find “multibagger” ideas.

This is especially true when it comes to large-cap stocks. That’s perhaps why even the world’s best known stock picker, the Oracle of Omaha, Warren Buffet, is a big proponent of passive investing.

In a recent interview to CNBC, Buffet said "Costs really matter in investments. If returns are going to be 7 or 8 percent and you're paying 1 percent for fees, that makes an enormous difference in how much money you're going to have in retirement."

He went on to add "The trick is not to pick the right company, but to essentially buy all the big companies through the S&P 500 and to do it consistently."

That’s important advice to keep in mind, but at the same time lets not forget that India is a much younger market than the US, thus active large-cap funds still have a role in your portfolio. The question is how much out-performance are they delivering to justify the additional cost they charge?

According to Morningstar India 58% of large-cap funds in India are still able to beat their benchmark.

“We analysed 5 year returns generated by 60 large-cap funds and found 35 of them could beat the BSE 100 Total Returns Index”, says Kaustabh Belapurkar, Director of Fund Research at Morningstar India.

Now that’s a pretty good hit rate. You just need to make sure that the large-cap fund you are investing in is one of these out-performers. That also brings me to the important concept of TRI or total return index.

Sebi has now made it mandatory for all fund houses to benchmark their funds’ performance against the corresponding total returns index vs the plain vanilla price return index.

The TRI includes all the dividends generated by companies that comprise the index and thus offers a much more fair and accurate idea of how well or poorly the fund is performing.

Before Sebi mandated TRI benchmarking, the mutual funds' net assets value would include dividends while the benchmark index wouldn’t, therefore offering us a skewed comparison. Thankfully this will now be a thing of the past.

SO WHAT DO I DO?

The key takeaway from this debate, as I see it, is that its time you start experimenting with passives. One can start by including some Nifty/Sensex index funds or ETFs in the portfolio.

They are low on risk and cost and thus the simplest way to begin. While experts differ on the exact proportion that should go in passives, a part of your large-cap investment can surely be made via passive funds.

Saurabh Mukherjea, CEO of Ambit Capital advises investing 30% of the corpus into large-cap stocks via the ETF or Index fund route. “Compounding costs really eat away a big chunk of returns in long term investing which is why I am a big proponent of passive funds” says Mukherjea.

As the Indian equity market matures the ability of large-cap funds to deliver consistently high out-performance may diminish. Having said that, India does boast of some of the finest fund managers, its just a question of ensuring that you are in the right funds.

Thus a little bit of homework and some quick planning with your financial advisor will get you the right blend of active and passives that puts you on the on the road to riches. Happy Investing!

Published : May 11, 2018 01:19 PM IST

Mutual funds: Time to go partially passive?

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