How you should blend passive and active investing strategies

The active versus passive investing debate in mutual funds is unlikely to have a clear winner. Data on performance and assets under management (AUM) indicates investors’ current disenchantment with actively managed funds. In fact, the mutual fund industry has seen a host of product launches in the passive investing space, ranging from plain-vanilla exchange-traded funds (ETFs) and index funds to sector- and theme- focused funds to the more complex smart beta offerings.

Ideally, it should not be an “either or” situation when it comes to active and passive investing, and the solution could lie in marrying the two styles. Here is how to bring both the strategies together.

Go Passive

Select a passive strategy where an active one is unable to beat the benchmark meaningfully to justify the expenses. A case in point are large-cap funds, which had their investment universe limited after the reclassification exercise in 2018.

“A core allocation to equity will benefit from a passive strategy for investors in the wealth accumulation phase seeking to participate in the country’s economic growth. It takes out the worry of choosing a strategy or process that is likely to outperform. Moreover, the cost advantage of a passive fund will translate into significant benefit over the long horizon,” said Anil Ghelani, senior vice-president, DSP Investment Managers.

Use index funds and ETFs to access unfamiliar markets. Investing in international markets brings diversification benefits and ETFs are a good way to include them in the portfolio. “The choice of vehicle to invest in international securities will depend upon what you are looking for. If it is a single country, say US large-cap exposure, then passive options are better. But for investment in a niche segment, active funds may be a better option,” said Ghelani.

In some cases, passive funds score on convenience over traditional investments such as in the case of gold. “Gold ETFs are also preferred where the investment period is shorter or to take tactical advantage of price movements,” said Lovaii Navlakhi, founder and CEO of International Money Matters Pvt. Ltd, a Sebi-registered investment advisory firm. He was comparing gold ETFs with the other investor favourite, Sovereign Gold Bonds.

Stay Active

Actively managed funds work best to implement flexible strategies that need to be regularly monitored. For example, in a flexicap or dynamic asset allocation fund, the investor depends upon the fund manager’s expertise to make changes in line with economic and market situations.

“Where active funds justify their cost with the potential to outperform the index, we would prefer them,” said Navlakhi.

Another space which works better with active intervention and greater flexibility are investments in markets that may be less efficient and liquid. For instance, investing in mid-caps beyond, say, the top 100 in the segment or in the small-cap space is best done with greater analysis and research by the fund manager. These segments could be quite illiquid too. “Big inflows or outflows into mid- and small-caps will be difficult to manage. Allocating to stocks or liquidating on the same day as required under a passive strategy may be challenging and lead to price distortions,” said Ghelani.

An active fund which is not limited by the stocks and proportions in which investments have to made, unlike an index fund, and which can choose to use the flexibility that Sebi rules give in holding cash or investing in the large-cap segment when valuations are high may be more efficient way to invest in this segment.

The illiquidity argument holds for an asset class like debt too as the lack of depth in Indian markets makes it difficult to execute a passive strategy. “The options available under the passive strategy in fixed-income is limited at the moment. For a portfolio’s need for debt, active funds offer options in various duration bands and strategies, including credit. They continue to be the best choice for the portfolio till such time that the product offerings in the passive space increase,” said Navlakhi. “There is some flexibility now on replicating a fixed income index and things will only get better in this space going forward,” added Ghelani.

What should you do?

There is no ideal combination of active and passive funds in a portfolio. One approach to combining the two strategies is to use index funds and ETFs for that portion of the core portfolio where you want consistency of strategy and rule-based long-term investments. This is, typically, in the large-cap segment. Use active funds to round off the equity portfolio with exposure to mid- and small-cap segments, depending on your risk preferences.

For tactical exposure in the equity markets, use active funds that adopt strategies that are expected to do well in the prevailing market and economic conditions. These include exposure to mid- and small-caps, funds with specific investment styles, thematic and sector funds and so on. Smart beta funds are another option as they blend the rule-based, lower-cost style of passive funds with specific investment strategies. However, they are more complex and you should get proper advice on their suitability.

The fixed-income allocation in a portfolio is best made with traditional debt products and actively-managed debt funds aligned to the investor’s holding period. Tactical exposure to debt fund strategies, such as roll-down and credit, can be done in both active or passive spaces, depending on what is available. Index funds and ETFs are also an efficient way to give the necessary allocation to international equity and gold in a portfolio.

For the active portion, you need to have the headspace to take periods of underperformance relative to the index. There may also be a wide divergence in the performance of funds in a category that will necessitate monitoring and switching where necessary. Passive funds have issues of greater concentration risk and not being able to benefit from early mover advantage that comes from actively tracking portfolio constituents. A blend of active and passive strategies does not take away the risks but allows for a more optimum mix of products to help reach your objectives.