Active vs passive funds: Can both play a role in your portfolio?

It's one of the most popular debates in the investment industry: should investors choose actively managed funds or passive funds, such as exchange-traded funds (ETFs) or index funds, which simply replicate an underlying index?

For the uninitiated, active funds are managed by fund managers and their teams, who decide which securities (stocks, bonds, etc.) to buy and sell, based on their market assessment and analysis of individual securities. Passive funds, on the other hand, do not make such decisions and, instead, invest exactly as per the underlying index.

Both approaches have their advantages. A fund manager, usually supported by a research team, has several resources at their disposal to conduct extensive research on individual securities. The manager may identify potentially good companies to invest in, which may outperform the market and generate what is termed as ‘alpha’—the additional returns the fund generates over and above what is expected, given the nature of the risks taken by the fund.

However, passive fund enthusiasts argue that the market consists of many experts, making it difficult for any particular manager (and, therefore a scheme) to generate alpha consistently. As a result, investors would be better off investing in the market than trying to choose an active fund. The usually higher expenses of active funds may not be justified.

While discussions on active versus passive investing often focus on cost (low cost of passive funds versus high cost of active funds) and the ability (or inability) of active fund managers to generate alpha consistently, there are other aspects for investors to consider when choosing strategies.

Is the strategy unique?

Both active and passive strategies may offer unique approaches available only in a specific format. For instance, several smart beta strategies offered under the passive banner are based on specific factors such as quality, momentum, equal weight, etc. Multiple factor models, like the Alpha LowVol strategy (which considers both alpha and low volatility), may not be available for active funds. These strategies could serve specific purposes within investor portfolios.

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Similarly, many hybrid strategies and multi-asset investing, where the fund invests across various asset classes, including equity, debt and commodities, are available only in the active format. Even within pure equity, several strategies are available only for the active format, and not for passives.

Investors should first choose the right strategies suitable to them, regardless of the format, and then deliberate on other aspects such as costs and the potential of the fund to deliver returns as expected.

Portfolio construction

The maximum single stock limit for active funds is 10%, whereas for passive funds, single stock exposure could be as high as 35%. Passive funds tend to be more concentrated than active funds. For example, while the Nifty Bank Index Funds (passive) may have only 12 stocks, with the weight of the top stock being as high as 30%, actively managed banking and financial services funds may have 40-50 stocks, with the top holding not more than 7-8%. These two strategies may not be comparable, let alone the discussions around alpha.

Concentration and diversification have their advantages and disadvantages. Investors should evaluate what suits them better. If an investor believes the banking sector is best played with the largest banks, they may prefer the index fund. Conversely, if they believe the entire banking and financial services sector would do well, they might choose the active strategy.

Rules vs discretion

The fundamental difference is that passive investing is rules-based, while active funds use discretion at various stages of fund management. A small-cap index fund (passive) offers 100% exposure to the small-cap universe of the market, investing in stocks ranked 251 to 500 by market capitalization, in the exact proportion as the small-cap index. This provides pure small-cap exposure. An actively managed small-cap fund, however, may take a diversified approach, typically investing 70-75% in small-cap and the rest in large-cap, mid-cap and, possibly, some cash.

Both approaches have merits and work in different market conditions. Investors should decide which approach suits their specific requirements.

Asset allocation

To start with, investors need to decide on asset allocation—how much to invest in equity, fixed income, gold, etc. Generally, the longer the investment horizon (e.g., three years or more), the higher the allocation to equity and gold can be. 

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The type of funds within each asset class should be decided next. For instance, within equity, how much should be allocated to large- or mid-cap funds, etc., if investors have specific views on sectors or themes. 

At this stage, investors can consider various active and passive strategies based on their preferences and requirements. Other aspects such as fund costs and the ability of fund managers to generate alpha consistently should be considered, but should certainly not be the primary focus of the investment decision.

Arun Sundaresan is head of ETF at Nippon Life India Asset Management

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