Passive Funds Could Be Your Best Shot At Constructing A Simple Core Portfolio

Passive funds have seen a new wave of traction among Indian investors, especially in new fund offerings. With 17 schemes launched last month, Rs 3,758 crore out of the inflows into the category was accounted for by NFOs.

The category has seen a marginal increase in assets under management, rising to Rs 11.45 lakh crore in September. When it comes to investing in passives, the general advice has always been to include actively managed large caps that make up one's core portfolio.

This is recommended because one's core portfolio needs to be made up by funds that are focused on delivering consistent returns over longer periods. One could add satellite funds that are more focused on generating higher rewards. These funds might receive lower allocations, according to the portfolio's risk tolerance.

"Objective of only passive is to increase penetration. Introducing products that are simple," said Vishal Jain, chief executive officer of Zerodha Fund House.

"Most passive funds have a tracking error impact of 0.67%. The AUM of the passive category is loaded toward Nifty 50 because that was where the money was in the past," he said.

Despite the top 50 being the investor's favourite, there have been diverse strategies that have been emerging recently. With a wider range of strategy—like momentum, growth and value—to choose from, the category is expanding. Passive funds have also outperformed the actively managed funds over longer time frames.

Passive products are bought not sold. Lower interest happens due to their lowering tracking error impact, said Jain. A tracking error is the difference between the scheme’s return and benchmark returns. The gap will be based on how closely the benchmark was replicated in the specific scheme.

The higher the difference from the benchmark returns, the higher the tracking error. Fund managers of actively managed schemes seek a higher tracking error for Alpha generation.

"Investors need to split their portfolio into core and satellite, the core should be simple, plain-vanilla schemes depending on how they manage their money," said Jain.

Despite passives being all-weather friendly, the schemes one picks should be based on their investment management, goals and market cycles.

"A prudent investor can allocate in the Nifty 50, Nifty Next 50 and Mid cap 150, while a more filtered approach can include investing in Nifty 250 or Nifty 500," he added.

Index funds have been able to deliver better returns than active funds. But mid and small caps is better actively managed. There needs to be balanced allocations and rebalancing, said Pankaj Mathpal, founder and managing director of Optima Money Managers Pvt.

"A simple core portfolio can be made with only passive and its absolutely good in the long run," said Mohit Gang, co-founder of Moneyfront.

Though passives are a good strategy, it is important to ensure that the allocations align with one's goals.

"A 50:50 mix between active and passive works through every season as you have all investing styles and flavours," he said. "The lack of ability to eliminate stocks is there, as one needs to buy the whole lot in passive funds," said Gang.