Why you should diversify your portfolio by investing in Index Funds

Mutual funds, as an investment option, have gained popularity in the past several years. Investing every month, popularly known as SIP (systematic investment plan), is more popular now, than ever before.

You all must have probably heard the term diversification while investing in the different asset class. In investment management, diversification is the process of assigning capital across different asset class in a manner that the overall risk of the portfolio reduces, and the returns increases.

The rationale behind the methodology is pretty simple – a portfolio comprising of a different kind of investment yield higher returns and pose a lower risk when compared to an individual investment within the portfolio.

In this blog, we seek to discuss why, as an investor, you should diversify your portfolio by investing in index funds.

Active and passive funds: In India, majority of the funds are actively managed funds in which a fund manager chooses the portfolio components based on a certain mandated that the scheme has. Within the mandate, the fund manager has the liberty to choose any instrument, asset class as per his choice but in the best interest of the portfolio. The main objective of these fund managers is to outperform the benchmark, after accounting for expenses, against which they are being measured.

Passive funds are the funds that just track a chosen index and seeks to replicate the performance of the said index by investing in the same stocks as the index, and in the same quantity. Such funds would keep rebalancing the portfolio to align with the chosen index. There is no skill involved in managing a passive fund as a fund manager is not mandated to take any investment calls. Due to this reason, the expenses incurred in managing such a fund is minimalistic.

What has been happening?

Off late, the active funds are increasingly finding it difficult to beat the passively managed index funds. After the categorization and rationalization of mutual fund schemes by the market regulator Securities and Exchange Board of India (SEBI), the large-cap funds are mandated to hold around 80% of the portfolio in stocks that belong to the top 100 shares by market capitalization. This approach makes it difficult for fund managers to generate alpha. Previously, when there was no such mandatory guideline by SEBI, the fund managers used to have some exposure to mid-cap stocks that helped the fund manager generate alpha.

Due to the categorization, the actively managed funds have failed to outperform the passively managed funds over the last one year period.

Other reasons which contribute to narrowing of the returns between the active fund and passive fund are – benchmarking with Total Return Index (which takes into account dividend and other accruals), underlying expenses differential which affects returns, maturing of Indian markets, and increased coverage of equities.

Diversification using passive investments

Passive investments make sense today given the active funds are not very successful in beating the benchmark with a considerable margin. Moreover, if these funds are unable to beat the passive funds, there is no sense in paying high management fees.

Let us look at the S&P Indices Versus Active Funds (SPIVA) India scorecard – a study that compared active and passive funds over a different period.

S&P BSE 100 w.r.t to Large-cap category

Source: S&P

If you look at the table above, in the large-cap category, over 90 percent of the actively managed funds under­performed the benchmark.

For a longer term of 1, 3, 5, and 10­ years, the data from SPIVA depicts that the passive funds beat the active funds in all except the five years (for equal weighted).

Source: S&P

For five year period also, the excess return is not materially high.

Due to factors discussed earlier, the outperformance of active funds over the index will become difficult. Thus, passive funds need to be allocated to the portfolio. So, it is wise that you diversify your portfolio and add index funds to get the exposure of the large-cap names to start with.

What is the right proportion?

For a young investor with a moderate risk appetite, deploying a quarter of ones’ portfolio to an index fund is a wise decision and helps an investor take part in the broader market segment. The remainder three-fourths can remain invested in actively managed mid-cap and small-cap funds that offer better alpha.

The proportion of active to passive funds and funds based on the market capitalization can change based on the risk appetite of the investor.

Benefits of investing in index funds

Index funds are low-cost funds that are truly diversified in nature and are mirrored to an existing index. These funds are managed with limited human intervention and seek to provide returns that are offered by the benchmark index. These funds are highly liquid and come with minimal management fees.

Also, index funds are generally fully invested when compared to other actively managed funds. These funds usually do not hold high cash position as may be the case with actively managed funds. Click on the link if you wish to read more about index funds from Orowealth.

Conclusion

To conclude, we can say that the Indian market is on the path of becoming a matured market but has a long way to go. The situation in India currently can be considered as a repeat telecast for something that has happened in the United States a couple of years ago.

The idea behind investing in pretty simple – it is advantage investors – doesn’t matter that if it is an active fund or passive funds. Having said that, the future for mutual funds seems interesting for the next couple of years. Amidst this one thing is sure – while active will stay for a while, but only street smart fund managers would find a mention in tomorrow’s news.