Is there a place for both active and passive index funds in your MF portfolio?

Many investors are already aware of the differences between active and passive funds. And if they are active on social media like X (formerly Twitter), they would also know how often the fans of both sides collide in futile keyboard battles. It is still early days in India for passive funds, but without doubt, there is a growing interest. But is it really necessary to choose only one type of fund (active or passive) for your portfolio? Can we not have schemes from both passive and active funds in our portfolios?

In my humble view, a good mix of active and passive funds is a better bet to build an optimal portfolio. Don’t get me wrong. I am not saying that being a passive-only investor is wrong. There is certainly a case to do that as well. But what I am offering here is my take on the same. 

Read more: How choosing an investment adviser helped this Mumbai family manage finances

Let’s talk about large-caps first. Recent data might show that active large-cap funds have done better ‘as of now’. But on close scrutiny of the rolling-returns data of the last several years, it is clearly evident that a majority of active large-cap funds are increasingly finding it difficult to beat the index (like Nifty50 TRI) consistently. Given the limited number of stocks in large-cap space (top-100 stocks by market-cap) and market regulator Sebi's categorization definitions, the ability of fund managers to generate alpha consistently via active large-cap funds is on a downtrend.

And due to this reducing probability and intensity of outperformance, I feel that you should take the passive route of index funds based on Nifty50/Sensex/Nifty100 for exposure to large-caps. Technically, even the Nifty Next50 index qualifies as large-cap, but its volatility-return nature is closer to mid-caps than large-caps.

Moving on, how do you invest in small and mid-caps (smids)? This is where active investing holds the real edge. When it comes to large-caps, these are widely tracked, and a lot of information is already available publicly. The information about businesses or stocks in smids segments is available less easily and hence, there is a potential for a good fund manager to do better research and show their mettle in stock-picking. Easier said than done but it is this angle that brings in the potential for alpha generation. And if you deep dive into the data, you will notice that a large proportion of active smids tend to do much better than benchmark indices or comparable passive funds.

Read more: Investors should take ownership of their investments

Another thing to note is that active large-cap funds beat the index occasionally but not by much. However, good smids tend to beat their benchmarks quite comprehensively. So even though the expenses of passive funds are low, the quantum of outperformance (or alpha over index) by active smids in good years more than compensates for the higher expenses.

Of course, there is no guarantee of active funds beating the index. But for some who identify as (at least) moderately aggressive investors, the potential for outperformance is a risk worth taking. Isn’t it? So, while I am all in favor for investing in pure passive funds for large-caps, I also advocate for active funds in the smids space. So, unless you are a very conservative investor, there is space for both fund types to coexist in your portfolio.

But whatever you do, don’t try to constantly shuttle between pure active to pure passive and vice-versa based on the last 1-2 years’ return. Either pick a side and stick with it for long, or as we deliberated above, keep funds from both sides in your diversified portfolio to cater to different market segments.

Dev Ashish is a registered investment adviser and founder of Stable Investor.