What’s the price for less regret?

Asset management companies are planning to unveil a number of defunct products, as indicated by filings available on SEBI’s website. These products may be suitable for an individual’s non-goal-based portfolio.

For a goal-oriented portfolio, your focus should be on large-cap index funds and ETFs. In this article, we look at the benefits and costs of investing in large-cap passive products.

passive profit

Firstly, investing in large-cap passive funds is practically optimal. You will regret it even if an active fund you buy generates positive alpha (traps the benchmark index) but underperforms other active funds you choose.

You can minimize this regret by choosing Nifty ETFs as all such funds will generate similar returns.

Second, the overall expense ratio for a passive product is much lower than for an active fund.

For example, an ETF charges 5 basis points whereas an active fund may cost more than 1%. After accounting for brokerage commissions for buying ETFs, the fees you save are available for investing through the time horizon toward the goal of life. Third, passive funds carry only market risk whereas active funds carry active risk in addition to market risk. That is, by investing in an active fund, you are exposed to the risk of the fund underperforming the index. If your objective is to achieve a goal like buying a home, then taking market exposure should be enough.

The total assets managed by active funds are higher than those managed by passive funds. Clearly, active funds have a certain appeal among investors. Why?

For one, an active fund can give you higher returns than a benchmark index during a market uptrend and less losses in a downtrend. Passive funds will generate lower returns than indices during an uptrend and larger losses in a downtrend because they do not generate positive alpha to offset the fees.

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Open-end index funds also suffer from the cash-drag issue. That is, such funds are forced to hold cash to meet redemption requests from unit holders. Such cash is called fractional cash. True, open-end active funds also suffer from the same issue. But such funds hold periodic liquidity in the market and generate high returns. This cash is called strategic cash. Active funds can effectively manage frictional and strategic cash flows to reduce cash crunch. Lower cash drag can improve fund returns.

Passive funds appear optimal in practice, yet active funds dominate the market. Because managers cannot consistently generate positive alpha, it becomes difficult to determine which active managers will outperform the index through the time horizon of your life goal!

conclusion

You should choose an active fund only if you are confident that the fund will generate positive alpha.

Then you should consider whether such active investment is to be carried forward beyond the age of 45 years. You can cut back on equity investments to reduce the impact of a market crash near retirement. If you choose an active fund that underperforms the market near retirement, your losses will be higher.

Your default choice should be ETFs. Buying a passive product does not mean that fund managers cannot generate positive alpha. This means that you are not willing to accept the uncertainty in alpha generation. Settling for lower returns on ETFs is the price you pay to reduce the regret associated with investing in active funds.

(The author provides training programs for individuals to manage their personal investments)

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