Your Money: How passive investing makes doing the right thing simple

By Shaily Gang

Rules make things simple. Do the right thing—if you apply this rule, you don’t have to judge a situation or person from its fairness perspective. Just keep it simple by doing the right thing and keep moving.

This is at the core of passive investing. In an active portfolio, the fund manager’s basis of decision is ground-up with bottom-up criteria being possibly different for different stocks at one point in time or different criteria at other points in time for the same stocks, at times taking a top down macro approach too.

In a passive portfolio, the index is rigid about two or three rules and allows flexibility on the rest. This makes things simpler— this simplicity gives room for consistency and discipline as it takes away the judgement from the act. The returns in passive investing are a function of this discipline.

Stocks in the index

The inclusion of stocks in the index is based on a set of rules applied to form the index and also applied at a set frequency to rebalance the index. In case of broad indices, the rules could be solely full market capitalisation or free float market capitalisation applied on a universe of stocks. Nifty 50 Index filters for impact cost and presence of derivative contracts. With time, the ‘good’ becomes bigger and the exposure towards ‘not-so-good’ reduces in the index, with the index constituents too undergoing a churn as the index gets reconstituted periodically.

The numbers of holdings in active portfolios are usually leaner as compared to indices which are wider (barring Nifty 50 and Nifty next 50). In some years active portfolios could do well and in some other, wide indices would do well. In 2020 point to point return differential between narrower and wider indices was not much while in 2021 it was high. However, three- or five-year rolling returns of the index and active funds should be compared. Diversifying investments through both approaches—active and passive—makes sense.

Sector indices

The rules for sector indices and thematic ones primarily emanate from eligible basic industries under AMFI industry classification followed by free float market cap. As the AMFI industry classification is arranged systematically to capture a particular sector or a theme, rule-based index construction works well. Further, weights assigning is a function of free float market cap and weights capping.

One can take sector exposure vide a sector index or an active sector fund. Not to forget that the active sector fund would take overweight and underweight positions as compared to the said sector index and try to achieve alpha. Diversification through both routes would be a great thing to do. Also, a thematic index could try to capture a sub segment of the sector, catering to a higher risk reward profile while the fund would have a good mix of steady earnings companies and high risk reward profile companies.

The passive fund or ETF that is tracking the said index would yield similar returns and not outperform the index. Your capacity to take drawdowns in your investments is like your ability for speed while running.

To keep participating in the markets, it is fine to be earning only market returns and not more. Earning market returns consistently and for a long period of time is much better than exiting the markets just because the quantum of drawdown that could hit you at a point in time in your chase of alpha or positive excess returns, is not in sync with your risk bearing temperament.

The writer is head, Products, Tata Asset Management.