The next-level passive equity strategy for ETF investors

Exchange-traded funds (ETFs) and index funds are winning the returns race if one were to compare their last one- and three-year returns with that of actively managed large-cap funds over the same period. The last one year has been particularly stark with large-cap passive funds delivering 12% average return compared to 6.5% for active large-cap funds. This may just be a current market phenomena, but it brings into question the decreasing ability of a majority of active managers to overtake benchmark returns consistently in the large-cap space. It also highlights the relevance of low-cost passive funds for the long-term equity fund investor, who until now was mostly focused on selecting a good fund manager. 

Equity ETFs and index funds together have total assets under management (AUM) of around ₹ 82,000 crore, about 16% of the AUM of actively managed equity diversified funds at around ₹ 5 trillion. Roughly half of this is thanks to EPFO, which started investing in ETFs and index funds in 2015,  rather than individual investors. Historical performance data also favours active managers, with distribution too leaning towards that side given high commissions. Plus, choices in ETFs and index funds are limited, as most of these are linked to Sensex and Nifty 50. Out of 64 passive equity funds in the domestic mutual fund market, only 20 are not linked to the two indices. 

As acceptance for passive funds improves—at least 16 new passive funds were launched in the last one year—it may be time to start having conversations about passive funds that track multi-factor indices that can potentially give better risk-adjusted return.

Factor-based indices and passive funds

Passive funds link their portfolios to a chosen underlying index and mirror that index. For example, an ETF or an index fund that tracks the Sensex will build a portfolio with the stocks and in the weight they appear in the underlying index; changes happen only when the composition of the index changes. 

Says Vishal Jain, head ETF, Reliance Nippon Life Asset Management Ltd, “Globally, the highest traded share is an ETF—that too by a large margin. The benchmark index is the most visible representation of the market and hence, globally bulk of the passive strategies are based on these.”

However, if you want to look beyond the obvious, you can build long-term portfolios linked to several other indices; at the moment only a handful of passive funds do this. Apart from the more concentrated sector-based or thematic indices for the average investor, there are strategic indices which may help not only in building long-term return expectations, but also at lower volatility. These are commonly referred to as smart beta indices. The term beta signifies that the portfolio is constructed relative to the market benchmark index portfolio, rather than relying on bottom-up stock selection from the entire universe of stocks. For example, the Nifty multi-factor indices consider a universe of stocks covered by Nifty 100 and Nifty Midcap 50 indices.

These indices constructed with stocks that have one or more of defined factors. For example, a single-factor smart beta index could be based on a 15% per annum return on equity (the factor for the index) in a universe of say the top 100 stocks by market capitalisation. Multi-factor indices consider more than one such filter. 

“Single factor indices tend to exhibit cyclicality and index behaviour then becomes bound by the prevalent market cycle at the time. Multi-factor indices, which are more popular globally, on the other hand, cut through this cyclicality and have shown to give better risk-adjusted returns across market cycles,” said Mukesh Agarwal, CEO, NSE Indices. According to a white paper published by NSE Indices, there are at least 1,200 factor-based indices globally with an AUM of around $5.5 billion; the total ETF AUM is slightly more that $5.2 trillion.

Opportunity in the  domestic MF market  

According to the published NSE Dashboard data, risk-adjusted returns from their multi-factor indices are much better than those from the benchmark Nifty 50 (see graph). These multi-factor indices are also well diversified with a mix of large- and mid-cap stocks.  

“One can’t deny the need for a low-cost investment option for investors who don’t want the risk of fund manager bias when it comes to picking stocks and sectors. If there are quantitative ways of getting better return at lower risk and still have a diversified portfolio at a low cost with presumably no churn, then it makes sense for investors,” said Munish Randev, a family office advisor and mentor. In other words, multi-factor index-based passive funds could be somewhere in between the classic passive and active funds, tracking an index with a defined selection of stocks but devoid of fund manager intervention. 

It may still be too early to start having these, as investors are only just beginning to see the benefits of simple benchmark-linked passive funds. 

“There needs to be some alternatives in the large-cap space as alpha is definitely under pressure; moving from price index total return index for benchmarking returns has also put pressure. Passive funds will see a pick up in demand over the next 1-2 years, but market for smart beta funds with multi factors will take some time to develop,” said Niranjan Avasthi, head product and marketing, Edelweiss Asset Management Ltd.

Jain is not convinced. “Factor based indices are still based on the opinion that certain factors work better than others. All this is based only on historical data and perhaps picking the best performers from an existing index, but can the outperformance continue forever or will market efficiency take over and neutralise gains at some stage in the future needs to be questioned,” he said.

It may be a while before these ideas in the passive fund space fructify into investor volumes. A lot will depend on how the asset managers approach them and how the distribution community takes to these. It’s not just the commissions, but also about the perception of advice that is missing for passive funds. Nevertheless, as it gets harder to beat straightforward benchmarks with active management, watch out for smart beta and strategic benchmark-linked ETFs and index funds which are well-placed in terms of risk-adjusted returns as alternatives to underperforming active large-cap funds.