Up to 50% of your large-cap allocation can be through passive funds

Increase or reduce allocation to passive funds in future, depending on data on outperformance by active funds

Indian investors have traditionally favoured actively managed funds. This is not surprising, since select active funds have fine long-term track records, and investors who stayed with them have created wealth for themselves. But it may be time for investors to change preferences, or at least modify them, and make some room for passive funds too in their portfolios.

The Indian investors’ preference for active funds is not hard to explain. Currently, after Sebi’s reclassification exercise, there are 135 unique diversified-equity funds. Eight-eight of them have at least a 10-year history. Of them, 32 have given returns of above 15 per cent since inception, the highest going up to 24.4 per cent.

However, in recent years, evidence is beginning to emerge that active fund managers are finding it difficult to beat their benchmarks, especially within the large-cap segment of the market (see table). Only 26.7 per cent of large-cap funds—which can invest in the top 100 stocks by market cap, a very well-tracked part of the market—have beaten their benchmarks over the past one year and only 6.9 per cent over the past three years. 

Fund managers say this has happened because only a handful of stocks within the Nifty—barely 5-10—have performed over the past couple of years while the rest have languished. It is very difficult for active fund managers, who have more diversified portfolios, to outperform when so few stocks are doing well. As and when earnings recover, and the broader market starts performing, active fund managers will start doing well again. The shift to total return indices (which includes dividend) as the benchmark has also made the job of active fund managers harder.  

However, there is other evidence to show that outperformance by funds in the large-cap category has been shrinking for quite some time now. An earlier study by Edelweiss Mutual Fund had found that the average three-year rolling excess return generated by large-cap funds over the Nifty 50 Total Return Index was 4 percentage points between 2000 and 2007. It shrank to just 1 percentage point between 2008 and 2017.

The latest S&P Indices Versus Active Funds (SPIVA) report (for end 2018) had shown that 64.23 per cent of large-cap funds were outperformed by their indices (or 35.77 per cent outperformed) over the 10-year period. In the mid- and small-cap category, 55.26 per cent funds were outperformed by their indices (or 44.74 per cent of funds outperformed). Thus, if less than half of active funds tend to beat their benchmarks over the long term, then investors should hedge their bets by taking some exposure to low-cost passive funds as well, where they are assured of market-equivalent returns.

What can you do? It would be rash to swing completely from active to passive funds. “Of your large-cap allocation, take about 50 per cent exposure to passive funds,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. Within the mid- and the small-cap categories, active fund managers have greater scope to outperform as this is a less-tracked territory and fund managers have greater scope of finding hidden gems or mis-priced stocks. Moreover, not too many passive options are available in this space. So make a beginning now on the large-cap side and in future act based on the data on outperformance by active funds.

Avail of low-cost advantage of passive funds: Sundeep Sikka, ED and CEO, Reliance Nippon Life Asset Management Ltd

The main benefits of passive funds for investors is that they are low cost. Typical expense ratios in Nifty-based Exchange Traded Funds (ETFs) range from 0.05-0.10 per cent per annum, as compared to 1 per cent for direct plans of active large-cap schemes. Over a 10-year investment horizon an investor will stand to save over 9 per cent in costs, which will automatically result in more of the investor’s money working for him. Since typical equity investments are for long-term financial goals, low-cost passive investments can serve investors well. Passive investing also eliminates risks of stock selection and fund manager selection.

Passive funds can also be used in combination with active funds using a core-satellite mix. The core part of the portfolio should generally be left untouched and modified only for periodic rebalancing or an allocation change. These funds should focus on low cost and broad diversification, instead of taking unnecessary risks to outperform. Passive funds are an ideal fit for this.

In the satellite portion, investors can consider strategies that they consider will generate alpha. This is where investors can put some money in products they feel can outperform.

 

Kalpen Parekh

Active fund managers who stick to their style over an entire cycle will outperform: Kalpen Parekh, President, DSP Investment Managers

For large-cap stocks, one year ago (in August 2018), if you looked at the weighted average performance for all the asset under management (AUM) compared to the BSE 100 Total Return Index (TRI), the alpha was -5 percentage points. The benchmark had done much better. That was the time when the top seven stocks had captured most of the returns. Fund managers could not possibly be fully invested in only these seven stocks.

At present, the one-year alpha is -0.3 percentage points. Thus, a large part of the underperformance has got neutralised. So, the situation is changing.

In the multi-cap category, where the universe is the Nifty 500, one year ago the alpha for the one-year period was -4 percentage points. Today it has moved to positive 1.26 percentage points.

So the alpha trend has improved significantly over the past one year because the polarisation in performance is reducing.

Each fund manager should have a certain framework for the kind of stocks he is going to buy to beat the benchmark. There will be phases in the market when stocks that belong to his framework will not do well. But so long as he sticks to his framework over a full market cycle of five-seven years, he will be able to generate better returns than the benchmark. 

Large-cap funds are having most difficulty beating benchmark
	Percentage of funds that have outperformed benchmark
Fund category	1-year	3-year	5-year
Large-cap	26.7	6.9	51.7
Multi-cap	46.7	37.0	60.0
Mid-cap 100	52.4	66.7	.
Small-cap	93.3	71.4	92.9
Source: mutualfundindia.com