Is overdependence on passive investing detrimental to portfolio health? | The Financial Express

Is overdependence on passive investing detrimental to portfolio health?

Investing is a long-term endeavour, and thoroughly researching each potential investment is essential

passive investing
Investing in ETFs can greatly diversify your portfolio. However, ETFs are not a great vehicle to build sectoral exposure. Representational image

By Rahul Bhutoria

The basic premise of passive investing lies in this famous quote “if you can’t beat them, join them.” Since it has become increasingly difficult in mature markets for active money managers to beat Benchmarks across capitalizations, passive investing & ETFs made more sense as it endeavours to neither outperform nor time the market. All these are the reasons that Indian ETFs receive an inflow of USD 10Bn apart from their increasing clamour in CY 2022. 

However, in the Indian context, things are slightly different. First, since it’s still a growing market & developing economy, there is a lot of room to discover stocks for an active fund manager, especially in the mid & small-cap space. The liquidity is far less in the stocks beyond the first 100 stocks on a market cap basis, and for many of the passive funds in the mid & small cap space, tracking error is far higher than acceptable levels.

Furthermore, reduced liquidity could influence pricing. This is a key reason that most larger passive funds & ETFs are centred around Largecaps, as it’s relatively easier to manoeuvre liquidity since they imitate an index. For example, India’s largest Large-cap ETF has an AUM of above 1.5 Lac crores, while the Largest Midcap ETF has an AUM of less than Rs 1000 crore. 

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With an actively managed fund, the investor pays for a manager to research, choose, and monitor investments, a cost not associated with passive investing and ETFs. While passive funds are considered based on tracking error, Active funds also have a tracking error, which we call Alpha. A positive Alpha over the benchmark essentially compensates for active management risk. 

While ETFs can provide investors with a diversified portfolio and low fees, there are some disadvantages to consider. One of the main drawbacks of passive investing is the inability to capitalize on market inefficiencies. With a passive strategy, investors rely on broad market indices to determine their investments. They are unable to take advantage of potential opportunities that may exist in certain sectors or stocks. This can result in lower absolute returns in some market conditions. Also, the passive fund may be forced to take positions in a very high PE stock, which an active investor would otherwise like to avoid. This is where active management and stock-picking strategies can be beneficial. For example, an ETF may not hold cash, while an active investor may use cash to take advantage of market conditions. 

While ETFs can provide quick and easy access to various markets and sectors, it also tends to fuel the so-called “Switch trade” phenomenon. During market duress, Investors turn to index funds as return prospects become clouded. This seems to be a re-balancing act as investors move away from their active counterparts to save on the expense cost of funds. This phenomenon is especially prominent right now, with inflows into index funds reaching 8,601 crores in November – the highest among funds with equity exposure.  This switch trade is visibly prominent with large-cap funds. The 12-month rolling cumulative inflows into passive funds reached 1.65 lakh crore in November 2022. 

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Investing in ETFs can greatly diversify your portfolio. However, ETFs are not a great vehicle to build sectoral exposure, as the sectors keep rotating. NIFTY IT gave a return of 23% in 2021, while its fortunes dwindled in 2022, and it delivered only 4.3%. Lack of customization can lead to missed opportunities too. For an investor, it makes sense to have an advisor’s input on building the sectoral part of the portfolio through active funds or invest in active funds that increase allocation to sectors based on markets. 

It’s important to remember that investing is a long-term endeavour, and thoroughly researching each potential investment is essential, even for something sounding as simple as passive investing & ETFs. It may be worthwhile to have large-cap exposure through passive funds & ETFs. Still, for mid & small-cap allocation of the portfolio, actively managed funds deliver better risk-adjusted returns. Investors should make informed decisions by taking the time to understand the market and increase the odds of success. Ultimately, investors should weigh the potential rewards against the risks associated with any investment before committing their capital.

The author is the Director and Co-Founder of Valtrust

(Disclaimer: Views expressed are personal and do not reflect the official position or policy of Financial Express Online. Reproducing this content without permission is prohibited)


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First published on: 15-01-2023 at 11:24 IST