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The Mutual Fund Show: How To Build A Passive Portfolio

Active or passive, the debate on what’s better for Indian investors isn’t settled.

A row of coloured ten pin bowling balls at an alley. Photographer: Emily Elconin/Bloomberg
A row of coloured ten pin bowling balls at an alley. Photographer: Emily Elconin/Bloomberg

Active or passive, the debate on what’s better for Indian investors isn’t settled. There are those who think mid and small caps offer an opportunity to build actively managed portfolios based on analysis. Still, positives of passive portfolios mirroring an index can’t be denied. Investors don’t have to research, costs are lower and large caps are largely similar.

In this week’s The Mutual Fund Show, BloombergQuint invited Gurmeet Chadha, co-founder and chief executive officer at Complete Circle Consultants; and Prableen Bajpai, founder of FinFix Research and Analytics, to design an ideal portfolio for an investor seeking a passive, all-weather portfolio.

Bajpai advocated a portfolio comprising:

  • Large-cap Indian equity funds based on Nifty 50 and Nifty 100
  • A global fund for diversification, mirroring Nasdaq 100 and/or an S&P 500.
  • A gold fund—via investments in a fund of fund.
  • A Nifty equal weight index fund to diversify.

Chadha suggested:

  • A Nifty 50 tracking fund with a 50% weight in the portfolio.
  • Investing up to 25% in a Nifty midcap fund for outperformance.
  • For diversification into an asset class with low correlation with Indian equities, a Nasdaq 100 ETF or fund of fund with weight of up to 15%.
  • A gold fund with a 10% weigh as a hedge against equities.

Both the advisers refrained from recommending a debt fund because of fewer choices. They also suggested that instead of a passive versus active approach, investors should consider a blend of both.

The advisers also recommended funds within each category.

Watch the interaction here:

Edited excerpts of the interaction:

This is like calling two restaurant owners and telling them, forget the food you are giving, but tell us the names of a few cloud kitchens which give good food. So, even if it goes against the grain of your business, I’m so happy that both of you have consented to come in and do the show with us. Prableen, I’ll start with you. What is it that you believe would be an ideal passive portfolio which would have all the ingredients for somebody who wants to spread his investments as well, have the safety and at the same time, chase returns?

PRABLEEN BAJPAI: Giving out a totally passive portfolio I think is a tough call to make because we actually don’t have enough strategies available in India as of now. So, I think we’ll come to the positives and negatives of passives later on and I’ll give my selection—the funds that I’ve picked. The first one being the large-cap space because I think that is the space which is much talked about also where what we say is, the fund managers magic has kind of evaporated and large-cap funds have not been actually able to beat a lot of their benchmarks as just about 3% of large-cap funds have beaten their benchmarks. So, I think this is a good core strategy for an investor to pick a fund which is investing in Nifty 50 because it has the prominent top 50 stocks and for somebody who is looking at another slightly larger coverage within the large-cap space, the Nifty 100 index.

I wanted you to tell me what the construct of your portfolio is, or what kind of categories are you recommending first?

PRABLEEN BAJPAI: The first one for large-cap is the Nifty 50 and the Nifty 100 indexes. The second is exposure to global markets where I’m going to recommend, NASDAQ 100 as well as S&P 500 depending on the choice of investors, and the third is going by the basic premise that one has to focus on asset allocation some exposure to gold wherein you can choose the fund of funds—I’m not taking ETFs here because it’s convenient for retail investors to invest by FOFs, so gold funds. Broadly these three categories and to top it up a bit of exposure to Nifty mid-cap 150, so we are able to cover the mid-cap space as well.

To each of these categories would you overexpose the portfolio to one particular category vis-à-vis the other?

PRABLEEN BAJPAI: It depends on your age, on your risk appetite and all the other factors but let’s consider somebody who is in his 40s for example and they’re okay with at least 60-70% equity exposure. I think there within the equity about 80% in Indian markets, about 20% can go to the U.S. if you have a longer horizon for global markets for that matter. Within the Indian markets, I think, of course, the stability comes from the large-caps in India and followed by the next 150 stocks which is our mid-cap space, and gold is again 5-10%. It depends on the personal choice. That’s broadly how I would split it. Then we don’t have too many options within the index but debt is a very important component but we still have lesser choices within the passive space actually. So, I’m not giving out the name there.

Gurmeet, what’s your portfolio construct, the reasons and the weightages of course?

GURMEET CHADHA: I broadly agree with what Prableen said in terms of the allocation. I would keep it a little simpler. Since I’m a Warren Buffett fan and he said in one of his AGMs, that he wants his wife to invest everything in S&P 500 after him. So, that’s coming from the biggest proponent of active investment managers.

I think passive investing is here to stay, it will pick up. Assuming we are making only a passive portfolio, my allocation would be Nifty 50, 50%. Keep it simple and the reason is that we did a comparative analysis of Nifty 50, Nifty Next 50 and even Nifty mid-cap 150 and I did not see any outperformance over long periods. Even in Nifty mid-cap, the outperformance is only of 50 basis points that only after the 10-years time frame. So actually Nifty 50 as beaten Nifty mid-cap 150 even in three years, five years and seven years horizons. So, 50% in Nifty 50 and that probably is also because of the concentration. We are seeing the big becoming bigger play out and that’s got to do with how we are seeing the polarisation there. So, 50% in Nifty 50, 25% in Nifty mid-cap 150 because you will have lumpy performance in the mid-cap space. So, in the last one year for example, it is 90% so you have to be—I won’t say tactical, but you have to get into mid-cap to take advantage of that lumpy year which you will get once in maybe three years, four years or five years.

Typically it comes after every three-four years if you do some back testing. So, 15% in NASDAQ, I’m a great believer that technology would be the greatest disrupter. Nifty, NASDAQ 100, ETF has beaten every possible index in 5, 10-15 years. It’s just like 23-24% CAGR. In fact, I did an analysis that had you even invested in the worst on the meltdown day, when the NASDAQ corrected 79%, it is still up six times. So, that is tremendous wealth creation that the NASDAQ 100 has done. The best tech disruptors will find its way eventually into NASDAQ which has 60% largely in Tech. So, 15% there and I agree with Prableen that once you get into the markets we are in and considering the lofty valuations that we are in about 5-10% to gold. That acts like a hedge as gold typically tends to do very well in pandemics and every three-four years we do get hit by something and the names keep changing.

Prableen, let me come to you and talk about the individual components of the three categories or the four categories that we spoke about. Tell us what are they and why so and is there a reason why you’re choosing these one or two funds vis-à-vis the other two that might be there?

PRABLEEN BAJPAI: One category that I missed out was the Nifty Equal 50 index. I think that is one index where we’ve seen a lot of polarisation within the Nifty 50 but that index because it gives equal weightage, it’s an interesting study. Since 1999 till now, it has actually outperformed given a 15.3% CAGR as compared to about 13.5% of Nifty 50. In the last five years there has been a lot of underperformance but in the last one year it has actually outperformed by almost 5%. So, I think that investors can also look at Nifty 50Equal but the investing routes and vehicles are limited. I think there’s only one DSP fund currently. So, there aren’t enough options there but I think the equal weight is also an interesting index which investors can look at.

The ones which I am going to talk about within the large-cap space, the UTI Nifty Index Fund because it’s got a very low expense ratio of just about 0.14%, it’s got a robust AUM of about Rs 3,000 crore; the biggest in fact in the category. So, the compensation of any Nifty Index fund would remain the same largely. So, there investors can actually look at some other criteria such as expense ratios and what kind of tracking error the fund has had and the other one is Axis Nifty 100 Index Fund because it combines the behaviour of Nifty 50 and Nifty Next 50. So, the whole of the large cap universe is covered and here again the expense ratio is just about 0.15% though the AUM is about 376. So, the good part with a tiny AUM in a passive strategy is that the expense ratios still are quite under check because your expenses as it is are low, you’re just replicating an index.

Within the global space NASDAQ 100 of course is my choice. I’m taking the route via Kotak this time the Kotak NASDAQ 100 and that is investing in NASDAQ 100 using the IShares ETF and again the expense ratio is just about 0.3%. NASDAQ100 is a composition of non-financial stocks in the U.S. It’s a composition of 100 stocks which also includes international stocks. So, about 2-3% of international allocation is there in NASDAQ, nothing in the financial space and the AUM of the current—this was just launched in January so it’s about a Rs 230 crore AUM. But when you’re going through a master fund, the main focus has to be on the master fund. So, here how IShares is going to perform has to be the bigger criteria because Kotak is just a vehicle to park the money into NASDAQ 100.

So, you’re on IShares and you like to expense ratio of the Kotak Fund?

PRABLEEN BAJPAI: IShares is one of the biggest names in passive investing so I’m going with that because the S&P fund—that we only have available from Motilal Oswal, the index fund and of course again S&P500 is giving you 80% market-cap exposure to the U.S. with about 27% in the top10 stocks but again, I think investors need to be very careful that they do need to pick both the funds because the top 10 allocations will almost be the same as these are market-cap based indices and all the companies which have higher market caps are carrying a higher weight, so they have to be careful there. Within gold, the SBI Gold Fund and the Kotak Gold Fund—they both are about Rs 800-900 crore of AUM with an expense ratio of 0.5%—both were launched in 2011. I think as a passive strategy it is good in terms of fund of fund because as an investor, I can choose whether I want to allocate 1000 a month to Gold or 5000 a month. You have the discretion to increase your allocation. So, as compared to an ETF, an FOF becomes a simpler model for a retail investor.

I’m just repeating this is one that the expense ratios and the tracking errors of the names that you’ve spoken about are probably the best available out there and the performance on the global side, you believe IShares would be able to do a great job on the ETF investing?

PRABLEEN BAJPAI: IShares is a very old brand and honestly, within passive investing the index which is going to be tracked is the main thing. So, these are just vehicles and there is not much difference honestly, whether you’re picking the ICICI Index Fund or the UTI Index Fund. I think investors can also go with expense ratios in their own comfort with a certain fund house if that be the case because there is no fund manager skill involvement in those things. So, I think they can actually take their pick whichever they feel comfortable with.

Gurmeet, you’ve given your categories and the weights. Now, within the categories, what are the one or two names, why and is there a reason why choosing them vis-à-vis the others?

GURMEET CHADHA: The Nifty 50 I agree with Prableen. We can choose either HDFC or the UTI Index Fund Nifty plan. HDFC is Rs 2,500 crore, UTI is I think Rs 3300 crore and both of them have the lowest tracking error. So, you can go with that. For large investors you can take a Nifty 50 ETF.

The ETF because if the amount is large, you can ask the fund house to create a lot for you and that could be in terms of expense maybe save you another 5 or 10 basis points provided the ETF is quite liquid because if it isn’t, you could end up buying at a premium and selling at a discount. So very large institutional clients and family offices can take ETFs, they are from the same family. It’s just that the convenience and retail investors can choose between either HDFC or UTI.

On mid-cap150, unfortunately there are very few options, large investors can take the Motilal 150 mid-cap ETF. The only issue is, it’s only Rs 50-60 crore (in assets under management). You have to be careful in terms of the amount you deploy and the impact costs. Those are extremely important. The other mid-cap funds don’t have much of a track record. So, there’s Nippon which is just like six weeks old and there’s a Birla mid-cap where the NFO just got concluded a couple of weeks ago. So, either of the two.

For a retail investor, Nippon mid-cap index fund and for an HNI or a large treasury debt you can take the Motilal Oswal 150 mid-cap ETF. With NASDAQ I would go with Motilal because it’s old, it has a track record, a lot of our clients have taken the exposure and so far they’ve managed their tracking error well and there’s not much choice between the two if you ask me but since it’s old it’s around 3000 crore. The FOF has done a relatively good job and I think one can go with that. On the Gold fund, I would go with ICICI Prudential Gold Savings Fund, it’s an FOF. If you see that for one year—because in Gold funds you have to be very clear of the tracking errors because they can vary. So, in the last one year, for example, the return ranges from 3% to 6 and-a- half-percent in Gold—one-year returns. So, that’s how big the tracking error is which is 30-40 basis points in a Nifty 50 fund. Over long periods ICICI and to an extent Kotak has had the least tracking error. Again, go for ETFs if the lot size is larger. Also, there are some fund houses which at some point in time were offering physical exchange of Gold provided a lot size is large enough.

I want to ask you that for people who don’t have large lot sizes, would you believe that an FOF would be a better option?

GURMEET CHADHA: Absolutely. I agree, an FOF is also convenient—you can do switches, you can do SIPs, you can do STPs. There’s a convenience thing which comes in which helps you in asset allocation in the longer scheme of things. ETFs can be tedious, you need to have a demat account, there is brokerage, there are impact costs so it’s only suited for large issuing clients. So, between ICICI and the Kotak Gold Fund you can choose any, the ratio remains 50, 25, 15 and 10. Nifty 50, mid-cap, NASDAQ and gold.

Gurmeet, when we are making an ideal portfolio and typically when we talk about asset allocation, there is some bit of a debt element that always comes in. Not some bit but a large bit of debt element which also comes in. As somebody who is advising financially and not just on the funds route and let’s say somebody is taking this passive route, the equity part is taken care of. If the Employee Provident Fund or the Public Provident Fund or the NPS is not taking care of the pseudo debt investments, is there then a lack of attractive options or plausible options on the debt side because of which you guys are not giving out a debt recommendation and maybe that could be looked at a couple of years down the line when more options come in?

GURMEET CHADHA: Partially, there are a lack of options. Also in the shorter end illiquid and all, already the expense of the normal funds and all are so low that the argument in equity of passive funds being less expensive doesn’t hold true at the shorter end. Illiquid overnight funds are 5-10 basis points expense ratio. On the medium to longer it does make a difference because the difference could be 20, 30-40 basis points and that can overall have a great impact. Bharat Bond ETF was a great initiative by Edelweiss. We are seeing a lot of HDL index funds, we are seeing a lot of G-sec index funds coming. So, at the longer end yes, because you will have their funds which are of constant majority and their funds which are rolled down and which work like a fixed maturity plan. It does make sense. So, Bharat Bond or a G-sec rolled down maturity fund does make sense. On the shorter end from a convenience point of view and the fact that there is not much difference, you can still continue with your regular liquid ultra-short term funds.

Prableen, just one quick follow up before we get to the passive versus and the applicability of this. You are mentioning something about an equal weight index and there is only one option. So, I wanted to ask you if would you still make it as an addition to your overall passive portfolio and would you recommend that even if there’s only one option out there or it’s okay if somebody doesn’t have it?

PRABLEEN BAJPAI: Of course, anybody can do without it but I think it’s a good option because when we talk about passives, one of the risks which we often talk about is the risk of over concentration. So, it is the top three stocks or the top four stocks or even sector wise, there’s always that concentration which is one of the risks in passive investing. Going with an equal weighted strategy I think it negates that risk and it is actually a better way to hold an index because you’re giving equal weightage to each component. So, especially the Nifty 50 where those 50 stocks are the largest stocks in the Indian markets—so having them in your portfolio in an equal weightage I think can actually result in better performance. I also checked the volatility or the risk side to it and that is almost comparable but the performance of the equal weightage has been better. So, I think with Reliance in double digits and HDFC in double digits, sometimes funds and other stocks which are doing well are not able to get their view so equal weightage there reduces your risk as well to some extent over dependence on a couple of stocks.

While a lot of you’ll have written about the need or your desire to have a passive portfolio should one, ideally have an only passive portfolio should one have a judicious mix or can one simply avoid this and still stick with entirely active? Now, Gurmeet I want to start this with you. What’s your sense here?

GURMEET CHADHA: I think it’s not one against the other. I think as you rightly pointed out it’s a nice judicious mix. Prableen made the point that large-cap funds are finding it difficult to outperform the benchmark and maybe large-cap probably would make more sense to add an index fund or a Nifty50 Fund or a Sensex fund, right? But I think Indian markets are still not as efficient as the U.S. and the rest of the world. Look at the sectoral weightages we have, we have financials at 40% and healthcare only at 4%. The entire Nifty Pharma Index is seven lakh crore, Technology S&P 500 has 28% weightage and we have 13%. So, I think that there are discrepancies and the way the even Nifty is churning stocks, there’s almost like a 25% churn issue.

So, we are in a dynamic disruptive world and Indian markets will evolve. We’ll probably get there in due course of time, I can’t put a timeframe. There are a lot of sectors which are not represented in India in the index properly the way they are represented in Europe and in the U.S. markets. So, I think it’s a nice mix—maybe for large-cap you can have a passive fund but I would say go with that right judicious mix of both. Let’s say if somebody is extremely active in markets, does a lot of research has a higher ratio of an active folio, and somebody who’s extremely passive and just buy and hold has a completely long stance on equity, probably the ratio of passive would be higher. So, there’s no standard formula but a nice mix I think would be better rather than this debate of which one will serve more.

Prableen, to you as well, should somebody make an all-passive portfolio or you think that would be a wrong strategy?

PRABLEEN BAJPAI: Of course, the shift towards passive I think is a global phenomenon. So, the compensation of passive in the U.S. was only about 3% in 1995. It went up to about 14% by 2005 and last year in March2020 it was about 41%. So, if 41% of mutual funds and ETFs are passive, we actually have more than 50% in active, even in the U.S. So, I think the U.S. markets which are very evolved and developed, they also have 41% now a year later, probably it’s about 44-45%. That means that it is a mix of both passive and active.

There’s a nice report by Vanguard which actually gives an approach which is called a core and satellite approach. So, usually we use the core and satellite approach for the core funds and then the riskier ones in the satellite. What they say is that you put some basic funds—the dal-roti like the large-cap as your core and then you can always have the satellite as your active funds. They say that the combination of these two as a core and satellite can actually build a more robust portfolio for the investors. So, your overall portfolio costs can come down, the fund manager risk comes down, yet you are also insulated by certain risks which just passive investing can bring—valuation risk being one of them. The way Tesla was added to S&P 500 and after a 500% rally a fund is active, 50 billion shares of Tesla had to be bought by passive fund managers and now Yes Bank is being added to Nifty Next 50.

Yes Bank is probably is not a fun share which everybody would want actually just by its inclusion into an index it has to be bought and also at a certain valuation. So, I think given the combination one can take care of the niche and kind of take care of the negatives which the other one brings—somewhere where the costs are high, somewhere there is not enough innovation, there is less opportunity, there is concentration. So, I think it brings out the best if you combine the two. There’s a very interesting report by the U.S. Federal Reserve Board, which actually talks about the risks of shifting from active to passive. So, they say that the redemption the liquidity risks reduce but the risk of concentration increases. So, I think a combination of the two in total for an investor can work out well. It’s not that one against the other just like Gurmeet said. It’s a combination I think, which should work and in India, I think there’s still enough room in the mid-cap space as about 25% funds did beat the index, the benchmark. So, I think the combination should work best here.