When to look at passive MFs

Such funds help when we lack the time or skill needed to track performance; lower expense ratio is a bonus

You know that investing in equity requires you to pick the right stocks at the right time. If that’s difficult, you choose an equity mutual fund. But your effort doesn’t end in picking a fund.

It’s also essential that you review your funds every year. Why? Because funds can slip and fall behind their benchmark or peers — meaning you’re earning less than you could be. The need to track fund performance and review portfolios has increased over the past few years as more funds struggle to stay steadily better than the market. This holds true whether you hold equity, debt, or hybrid funds.

Enter passive

For those who have the time and the ability, weeding out poor performers, picking quality funds and reviewing is not a hard task. It gets difficult if:

One, you do not have the guidance, time or knowledge to identify under performers or outperformers, whether in portfolio review or making fresh investments. Two, even if you do, you always wonder if you should give the fund more time to perform or exit right away. Three, you don’t know the impact of any change in fund strategies and how it can impact you.

The solution is passive mutual funds and/or ETFs. A passive fund mimics the returns of a specific index (equity index or debt). It does not seek to beat the index. You don’t need to either worry about fund management or understand fund strategy. Also, passive funds have lower expense ratios than active funds. But a good portfolio needs balance, to broad-base where returns are coming from and mitigate the risk from specific market segments. Here’s how to go about it.

Equity options

The plain-vanilla Nifty 50, the Nifty 100 or the Sensex work very well to give your portfolio the fundamental large-cap exposure it needs. The Nifty 100 is very similar to the Nifty 50 in returns and behaviour, so don’t use both indices in the same portfolio.

To tap into higher returns — with higher risk — you have three options. The first is the Nifty Midcap 150, which represents the full mid-cap market segment; the index shows up well against even active mid-cap equity funds. The available BSE mid-cap index funds do not compare well in returns against the Nifty Midcap 150. The second is the Nifty Next 50; while this comprises large-cap stocks, its behaviour is similar to that of a mid-cap and is a high-volatile, high-return index. The third is the Nifty 500 or the BSE 500 — both indices represent the entire market and are good portfolio diversifiers. These indices provide enough of a return boost without the need to go for small-cap indices.

The Nifty 50 or the Sensex is a portfolio must-have and should form the primary allocation. Layer on the other return-booster indices based on the risk you’re willing to take and your time frame. Longer time frames allow for higher allocations to the high-risk indices. Cap allocations to these indices at 30-35%. If your time frame is less than 5 years, stick to the Nifty 50 or Sensex. If you’re looking for higher return, use the Nifty Next 50.

For the more sophisticated, these are factor indices – indices that take a main index such as the Nifty 100, apply factors such as alpha, volatility, value and so on to it, and create an index that exhibits defined characteristics.

You can use these indices to tap different strategies and diversify your portfolio. But be aware that you need to understand the factors and the index performance and how the index fits in your portfolio. ETFs such as Nifty Low Vol 30 and Nifty Alpha Low Vol 30 are examples of factor indices.

Finally, you can hold the U.S. market through index funds built on the Nasdaq 100 and the S&P 500. In all these indices, avoid making them the primary part of your portfolio – that should still be the market-cap based indices mentioned earlier.

Debt, gold

Gold funds/ETFs that track domestic gold prices are aplenty. If you want to add gold allocation, include up to 15% of your portfolio in gold as long as your time frame is longer than 4 years.

On the debt side, options are few, but this space too is evolving and more opportunities can come by. Currently, the easiest is Liquid ETFs. In the short-term space, you don’t have other options. But once you cross into longer-term time frames, consider PSU bond ETFs/ index funds such as the Bharat Bond indices, PSU Bond and State Development Loan ETFs/index funds and gilt ETFs. Go for them based on your holding time frame and the index’s maturity profile.

Points to note

In choosing index funds or ETFs, it’s important to check how well the fund/ETF mimics the actual index return (called tracking error). You still need to do asset-allocation between equity and debt, before then deciding on which index to use. And finally, in passive funds, let go of the need for ‘best’ returns. It’s enough that you mimic market returns.

(The author is Co-founder, PrimeInvestor.in)

Source: Read Full Article