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Allocating to passive mutual funds in one's portfolio is increasingly making sense

Passive investments makes sense today as increasingly active ones are unable to beat it most times.

Updated: May 25, 2019, 10.34 AM IST
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Active funds are increasingly finding it difficult to beat such passively managed index funds.
By Suresh Sadagopan

Mutual funds have become fairly popular as an investment option in the past several years. Investing on a monthly basis, - popularly known as SIP (systematic investment plan), is even more popular now, than ever before. Let us look at various MF segments and examine their appropriateness in your investment portfolio.

Regular and direct plans: Fund houses have thousands of distributors who canvass business for them and get paid through commissions on the assets brought in by them. The distributor led plans are called regular plans in industry parlance and the expense ratio of such schemes will be higher, as it includes distributor commissions as well.

A new version of these schemes, called direct plan, has been introduced to serve investors who are financially savvy and can pick up schemes on their own as also invest by themselves. These direct plans bypass the distributor and have lower expenses charged to them, as there are no commissions involved here.

Both regular and direct plans have the same portfolios and are managed in exactly the same manner. Their net asset values (NAVs) will be different as these plan variants have come in at different points and the expenses charged on an ongoing basis, is also different.

Active and passive funds: Most of the funds in the MF industry are actively managed funds, in that a fund manager would choose the portfolio components based on a certain mandate that the scheme has. But within that mandate, the fund manager can choose whichever equity/ debt component they feel is appropriate. Each scheme will have a chosen index which is the benchmark they track. Active funds have a team of fund managers and analysts whose intention is to beat the benchmark, after accounting for expenses.

There are other funds which are passively managed in that it just tracks a chosen index. These are called index funds. Such funds would just mimic the allocations in the index and keep rebalancing the portfolio, to align with the index. There is no skill involved in this and a fund manager is not needed to take stock-wise investment calls. Due to this, the expenses in such schemes are low.

Active funds are increasingly finding it difficult to beat such passively managed index funds. Some of the reasons are: tighter reclassification of categories as mandated by SEBI, benchmarking with Total Return Index (which takes into account dividend and other accruals), underlying expenses differential which has an effect on returns, maturing of Indian markets, and increased coverage of equities.

Exchange-traded funds (ETFs): Apart from the index funds mentioned earlier, there are other passively managed funds called ETFs. These also track an index, are traded on the stock exchanges and have low expense ratios. Since these schemes are traded on the stock exchanges, the price of the units change all through the trading session (unlike an NAV at the end of the day).

ETFs will require a demat account while with index funds, it is optional. In ETFs, just like in the case of equity shares, the units can be sold only if there is someone to buy the units. Hence, liquidity can be an issue, unlike in the case of MF units where the counter party is the fund house and liquidity is assured.

Also, the monthly investment setup cannot be a standard rupee amount. It will have to be a certain number of units (just like in the case of shares, where fractional share purchase is not possible). Setting up a monthly investment is possible in some portals, not everywhere.

The need for passive investments
Passive investments makes sense today as increasingly active ones are unable to beat it most times. If active funds are unable to beat the passive funds, there is not much meaning in paying a fee for it.

S&P Indices versus Active Funds (SPIVA) India score card is a study that compares the performance of active funds versus the index over various time periods. The study findings are revealing.

Latest data is available as of calendar year 2018. In the last one year in the category of large-cap funds, over 91.94 percent of the actively managed funds under-performed the benchmark.

Data available for 1-,3-,5- and 10-years shows that the index beats the active funds in all except in the five-year period, both in equal weighted and asset weighted returns. Even in 5 years, the excess return is just 0.17 percent and & 0.61 percent, respectively.

Average Performance ( Equal Weighted )
1 yr 3 yr 5 yr 10 yr
S&P BSE 100 2.62 12.83 13.58 16.08
Large cap category -3.19 10.09 13.75 15.08
Average Performance ( Asset Weighted )
1 yr 3 yr 5 yr 10 yr
S&P BSE 100 2.62 12.83 13.58 16.08
Large cap category -2.58 10.8 14.19 15.8
Data from SPIVA India scorecard

Equal weighting does not distinguish between a Rs100 crore fund and Rs 10,000 crore fund returns and shows the funds' average returns. Asset weighted return would assign appropriate weights based on asset value and reflects the return of a rupee deployed in the category.

In a nutshell, equal weighted average return shows the average return by the funds in the large cap category, without accounting for the individual fund size. Asset weighted returns shows the average return of a rupee, invested in this basket of funds, which is hence a better indicator.

Another thing to note is that the index has outperformed a good percentage of active funds, across time periods. (See table below). Due to factors discussed earlier, outperformance of active funds over the index will become more and more difficult.

Data from SPIVA India scorecard

Hence, passive funds will need to be allocated to portfolios, more and more. To start with, passives can come in at least the large-cap categories and overtime can move down to mid-caps and all-cap categories. One can even look at Smartbeta funds for inclusion in the portfolio.

The situation in India looks well poised for a repeat of what has happened in the US, with respect to passive investments. It's advantage investors. Future looks interesting indeed.

(The author is a SEBI RIA & Founder of Ladder7 Financial Advisories, a fee-only financial planning firm.)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of

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