Passive funds: Select ones with low tracking error, say experts

In case of an ETF, prefer those that also have large trading volume and AUM

With Indian investors warming up toward passive investing, fund houses have been launching exchange-traded funds (ETFs) and index funds at a rapid pace. The assets under management (AUM) of index funds stood at Rs 112,603.2 crore on October 31, 2022, up 200 per cent year-on-year (YoY). ETFs’ (excluding gold) AUM stood at Rs 482,654.6 crore, up 30.3 per cent YoY, according to the Association of Mutual Funds in India (Amfi) data.

Why go passive

According to the S&P Indices Versus Active Funds (SPIVA) India Scorecard, 67.4 per cent large-cap schemes underperformed the S&P BSE 100 index over the 10-year period which ended on June 30, 2022. As for mid-cap and small-cap funds, 46.9 per cent underperformed the S&P BSE 400 MidSmallcap Index.

Due to uncertainty regarding whether an active fund will outperform, a growing number of investors nowadays prefer passive funds, which do away with fund manager risk. “Passively managed funds have two advantages: lower cost and rule-based investing which reduces behavioural biases. But they also have a few shortcomings. There is no flexibility to change the portfolio based on human judgment. These funds also can’t outperform the benchmark,” says Arun Kumar, head of research, FundsIndia.

How to build a passive portfolio

First decide on your asset allocation to equities, bonds and gold, and then on your allocation to sub-segments (like large, mid-cap and small-cap in equities). Finally, choose the appropriate index funds or ETFs that offer exposure to these asset or sub-asset classes.

Investors also need to decide on the market segments for which they should opt for passive funds.

“Go with passive funds in the large-cap space, given the low percentage of active funds that outperform their benchmarks. The expense ratio differential between active and passive funds in this category also works in favour of the latter,” says Kumar.

For the mid-cap and small-cap space, he believes active funds remain a better choice. “The percentage of active funds that outperform is relatively higher in this segment. Moreover, institutional participation is still not very high here,” says Kumar.

Index fund or ETF?

ETFs are generally cheaper than index funds. However, one needs a demat-brokerage account to purchase ETFs. Also, the systematic investment plan (SIP) facility for purchases at regular intervals is not available in ETFs.

Index funds and fund of funds (which invest in units of an ETF) offer the SIP route. “Investors who want to invest at regular intervals should opt for SIP in index funds by giving a one-time instruction to the fund house,” says Hitendra Parekh, fund manager, Quantum Asset Management Company.

According to Kumar, index funds are better suited for long-term investors.

Those who wish to take advantage of an intraday fall in the net asset value (NAV) should go for an ETF. “However, liquidity is a concern in a large number of ETFs that have low trading volumes. If an investor is not careful, he may end up buying or selling an ETF at a significant differential to the underlying NAV,” says Kumar.

Parekh suggests using tracking error and tracking difference as the criteria for selecting an index fund or ETF from the many available. In the case of ETFs, go with one that has large trading volume on the stock exchanges.
  

Novices should begin with passive funds

New investors should opt for passive funds. “Investors who are just beginning their equity exposure and don’t know anything about the rationale for equity investing or about active funds should start with passive funds, preferably large-cap indices like the Nifty50 or the Sensex 30,” says Parekh.

Kumar suggests a mix of passive and active funds. “Do-it-yourself (DIY) novice investors, who don’t have the time and the expertise to pick active funds can look at plain vanilla passive equity funds. Alternatively, they can start with a 50 per cent active (diversified across different investment styles) and 50 per cent passive exposure (predominantly large-cap) and gradually tilt towards active or passive over time,” says Kumar.