Stick to passive funds in your core portfolio, say analysts

Investors who wish to chase alpha may use active funds and factor-based funds in the satellite portfolio

The latest SPIVA (S&P indices versus active funds) scorecard is out. It confirms a trend that has been taking shape for the past several years. Over the 10-year period ended December 2021, 67.6 per cent of large-cap funds have underperformed their benchmark (S&P BSE 100) while mid-cap and small-cap funds have fared slightly better: 56.1 per cent have underperformed their benchmark (S&P BSE 400 midsmallcap index).

Fewer outperformers

Two trends are discernible. “The level of alpha has been shrinking and the number of funds that beat their benchmarks has also been falling,” says Kaustubh Belapurkar, director, manager research, Morningstar Investment Adviser India.

This trend is unlikely to reverse. “Even in the future, it is going to be extremely difficult for fund managers in the large-cap space to beat their benchmarks,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India (Sebi) registered investment advisor. Gaining an information edge is difficult in this heavily-tracked space.

A minority of fund managers may continue to beat their benchmarks. “Investors need to be very selective in choosing their fund managers. If they can’t do so themselves, they should take an advisor’s help,” says Belapurkar.

Outperformance is more likely in the less tracked mid-cap and small-cap space.

Passive funds for core portfolio

Build your core portfolio using passive funds based on market-cap based indices. Allocate 50 per cent each to a Nifty 50 based fund and a diversified US equity index (total stock market, S&P 500, or NASDAQ, depending on availability).

With this portfolio, investors will be able to generate market-equivalent performance. The core portion should constitute the bulk of the portfolio.

This strategy is easy to stick to for the long term. The investor doesn’t have to worry about choosing the right fund manager, or switching funds due to underperformance by the fund manager.

In the satellite portion, the investor can chase alpha. Here, an investor can take exposure to whichever strategy she/he feels will do well (mid-cap, small-cap, value, growth, quality, momentum, etc). The investor may take this exposure using an active fund, a factor-based fund (where the portfolio is constructed based on fixed rules).

Pay heed to tracking difference

Between an index fund and an exchange-traded fund (ETF), most retail investors would find an index fund more suitable. It doesn’t require a brokerage-cum-demat account and the investor can go for a systematic investment plan (SIP). “Go for an index fund with a lower tracking difference. This variable reflects both expense ratio and the fund manager’s skill in tracking the index,” says Raghaw.

Avoid very small funds, whose performance could be affected by large inflows and outflows.

When choosing an ETF, besides tracking difference, liquidity is important. “Go for an ETF that has maintained a traded value of at least Rs 1 crore every day over the past month,” says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries (this data is available on the National Stock Exchange website. Search for an ETF, on its page, click on Historical Data, then look at the value.)

Go for an ETF that is tax efficient. “Avoid one that pays dividends,” says Luthria.

Rein in cost by opting for a low-cost broker.

Look for consistency

When selecting an active fund, look for consistency. “Whatever style the fund manager follows, the investor must not deviate from it. Use the style box to judge consistency,” says Belapurkar.

Use rolling return to assess performance: five-year return rolled monthly for five years (60 data points). Go for a fund that has a higher average rolling return. Look up the range of returns to evaluate volatility.

Belapurkar says all fund management styles will underperform during certain periods. Investors should stay invested during such periods as hopping from one fund to another would hurt portfolio return.

Currently, most factor-based funds have a limited history. They have yet to be tested on their ability to generate outperformance once corpus size grows large. Use them selectively for exposure to specific styles.