Passively managed funds have been growing in popularity with exchange-traded funds (ETFs) and index funds accounting for ₹1.31 trillion worth of net inflows over the past one year. While passive investing should be approached in the same disciplined way as any other form of investing, long-term wealth creation should be built around broad market indices rather than thematic passive funds, says Hemen Bhatia, executive director and chief executive officer of Angel One Asset Management Company.
In an interview with Mint, the former member of the team at Benchmark AMC that pioneered passive investing in India shares insights into the nuances of investing in passive funds. Edited excerpts.
How can an investor pick simple passive funds for their portfolio?
Passive investing should be approached in the same disciplined way as any other form of investing. It is not merely about buying an index fund and forgetting it, but about building a well-thought-out portfolio that aligns with one’s goals, risk appetite, and time horizon. A useful framework for investors is to think in terms of a core portfolio and a satellite portfolio.
The core portfolio should form the foundation of long-term wealth creation and should be built around broad market indices. In India today, the broadest such option is the Nifty Total Market Index, which covers nearly 750 stocks across large-cap, mid-cap, and small-cap segments.
By investing in such a diversified index, an investor gets exposure to almost the entire market and captures overall market returns, or market beta, in a simple and cost-efficient manner.
Alternatively, investors can construct their core portfolio by combining different market-cap indices such as Nifty 50, Nifty Next 50, Nifty Midcap 150, and Nifty Smallcap 250. This approach allows them to decide allocations based on their individual risk profile.
A conservative investor may prefer a higher weight in large caps, while a more aggressive investor may tilt towards mid- and small-cap segments.
One of the key advantages of a broad market index is that rebalancing across market segments happens automatically. As companies grow or shrink in size, their weight in the index changes accordingly. This internal rebalancing removes the burden of manual adjustments for the investor.
However, if an investor wants a different exposure to mid- and small-cap segments compared to what the Nifty Total Market Index provides, they can achieve this by buying separate indices and managing allocations themselves.
What should investors opt for between index funds and ETFs?
When choosing between index funds and exchange-traded funds (ETFs), investors should focus on convenience, cost, and their preferred mode of investing. Both vehicles track the same indices and aim to deliver similar returns over the long term. While ETFs require a demat account and are traded on exchanges, index funds can be bought directly from fund platforms.
With ETFs, you can get intraday prices, as they are bought and sold on exchanges during market hours. With index funds, you get end-of-day NAV (net asset value). Investors who want to do systematic investment plans (SIPs), index is a better choice as it operates like a fund structure, which makes SIP investments easier.
Is there a risk of ETFs trading at premiums, as we recently saw with silver ETFs?
Prices of silver ETFs are linked to physical silver. When investors buy units of a silver ETF, asset management companies are required to purchase physical silver in proportion to the investment value.
Recently, silver ETFs were trading at a premium due to a peculiar situation. Investor inflows into these funds surged sharply, while the supply of physical silver in the domestic market took time to materialise.
This temporary mismatch between demand and supply led to higher prices for ETF units compared with their underlying value. Otherwise, in normal market conditions, ETFs generally trade close to their iNAVs (indicative net asset value). Investors need to be careful during extreme market volatility when ETF prices may see distortion.
What are the passive options on the debt side?
On the debt side, the options are limited right now. It is also because Indian debt markets are not as liquid. However, there are options such as G-sec ETF and index funds that track the returns of government securities across different maturities.
Right now, it is not easy to do a product linked to corporate bonds because market-making is not easy. Bond prices are not available live, so it is difficult to price the units on the exchange.
What should investors be cautious about when investing in passive products?
Investors need to be cautious when considering theme-based or sector-based passive funds. In thematic and sector funds, timing plays a crucial role, as getting the entry and exit right can significantly impact returns.
These themes and sectors can go through prolonged periods of underperformance or outperformance, depending on economic conditions, policy changes, and industry-specific factors.
Investors who still wish to allocate to sectoral or thematic funds may consider doing so as part of their satellite portfolio, rather than as core holdings. Factor-based funds can also be included in the satellite portion of a portfolio. Different investment factors tend to perform well in different phases of the market cycle.
However, it is advisable to combine multiple factors—a two-factor strategy—with low correlation. This diversification helps balance performance, as weaker phases in one factor may be offset by stronger returns from another.