Benefit from both actively managed funds and ETFs
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Like all other decisions in life, investing too can often be marred by emotional choices and psychological banners. So, it is not necessary that only lay investors take biased calls. Even fund managers are subject to it. Hence, emerges the prolonged and intense debate—whether one should rely on exchange-traded funds (ETFs), which are passively managed, or actively managed funds? Both the investing strategies have their distinct pros and cons. I will analyse both these techniques and also evaluate if they can co-exist in a portfolio.
What is active investing?
As the name suggests, active investing is all about making investment decisions actively. This method is employed in an attempt to beat market returns as represented by an appropriate benchmark index. As such, it amounts to buying or selling individual stocks, which depends upon fundamentals, financial position and also the perception regarding the stock prices.
The core idea behind active investing is to take benefit of the valuation gaps prevailing in the market and which may be justified by the fundamentals of the company. Thus, the basic premise is to capitalize on market inefficiencies or pricing anomalies. The decision involves research, analysis of market trends and conditions, timing, sector calls, and so on. However, predicting future market movements or stock prices on a continuous basis is just not possible.
Further, news and future events, which are at times unpredictable and random, also drive stock prices. This simple logic makes it impossible for any human being to actively pick stocks, managers or sectors that may consistently outperform the average market. New events or information that move the stock prices get incorporated into the market price of security within minutes. Thus, whatever is known by market participants is instantly discounted in the current market price.
Since this is not an easy task, active investors often retain the services and expertise of professional fund managers by investing in actively managed mutual funds. Fund managers stay alert about the companies already existing in their portfolio and further, on the companies on the watch list.
What is ETF investing?
ETF investing, or passive investing, as it is commonly known as, is precisely opposite to active investing. This method tracks the portfolio pattern of underlying indices or benchmarks. For instance, Nifty ETF would own every stock in the NSE Nifty50 index in the same proportion as in the market index.
Since passive investors need to replicate the benchmark index, the portfolio turnover is minimal depending upon the changes in the benchmark index and thus, ETFs have a lower cost structure as compared to active investors regarding annual portfolio management charges, expense ratios, brokerage, transaction costs and other charges.
Passive investors tend to have an enduring belief in the power of markets and aim to harness the power of markets via representative portfolios or indices.
Thus, a passive investor, by only investing in the market indices, is eliminating non-systematic risks like stock specific and fund manager risk. The risk is limited to a systematic one, which is common to all methods of investing. However, while a passive investor reduces his overall investment risk, he also gives up the chance of generating alpha, i.e., making better returns than what the benchmark gives.
As markets become more and more competitive, it becomes difficult to locate and capture pricing anomalies. Therefore, it may be worthwhile to forego the active investment style in such a scenario as there are higher chances of underperforming the market. In the current Indian context, data demonstrates high market efficiency in the large-cap equity segment.
Hence, allocating assets to passive products is a proven low-cost passive vehicle for implementing the passive investing philosophy. Examples of passive investment products are gold ETFs tracking gold prices, Sensex ETFs tracking Sensex, midcap ETFs tracking Midcap 100 index, and others.
Is there a middle way?
Amid all this analysis, one must be curious if there is a method between the two strategies that adopts the benefits of both. It is indeed preferable to select a core and satellite approach for efficient portfolio construction. ETFs can help by providing a diversified exposure within an investment portfolio. Depending on risk appetite and suitability, one of the two methods (active and passive investing) could form the ‘core’ of your portfolio, and the other could be the ‘satellite.’
For instance, if you have a conservative risk appetite, build a core portfolio of ETFs providing a way to reduce the running costs of a portfolio without deviating too much from the benchmark. It is indeed helpful in stock segments where the alpha returns are lower due to lesser probabilities of valuation mismatch, for instance in large-cap stocks. The remaining part of the portfolio (satellite) can be actively managed through investments in selected equities or actively managed assets such as stocks, other mutual fund schemes, or sectoral allocation.
The aim can be to generate alpha through picking investments that may outperform the core portion of the portfolio. You can balance your risk-reward ratio and get better returns from the portfolio. In case of a high-risk appetite individual, the opposite may be suitable. In the end, an ideal portfolio is one which captures the best of both worlds.
Sundeep Sikka, executive director and chief executive officer, Reliance Nippon Life Asset Management Ltd