Is overdependence on passive investing detrimental to portfolio health?

By Rahul Bhutoria

The basic premise of passive investing lies in this famous quote “if you can’t beat them, join them.” Since it has become increasingly difficult in mature markets for active money managers to beat Benchmarks across capitalizations, passive investing & ETFs made more sense as it endeavours to neither outperform nor time the market. All these are the reasons that Indian ETFs receive an inflow of USD 10Bn apart from their increasing clamour in CY 2022. 

However, in the Indian context, things are slightly different. First, since it’s still a growing market & developing economy, there is a lot of room to discover stocks for an active fund manager, especially in the mid & small-cap space. The liquidity is far less in the stocks beyond the first 100 stocks on a market cap basis, and for many of the passive funds in the mid & small cap space, tracking error is far higher than acceptable levels.

Furthermore, reduced liquidity could influence pricing. This is a key reason that most larger passive funds & ETFs are centred around Largecaps, as it’s relatively easier to manoeuvre liquidity since they imitate an index. For example, India’s largest Large-cap ETF has an AUM of above 1.5 Lac crores, while the Largest Midcap ETF has an AUM of less than Rs 1000 crore. 

Also Read: Will you benefit from Passive ELSS schemes? 5 points

With an actively managed fund, the investor pays for a manager to research, choose, and monitor investments, a cost not associated with passive investing and ETFs. While passive funds are considered based on tracking error, Active funds also have a tracking error, which we call Alpha. A positive Alpha over the benchmark essentially compensates for active management risk. 

While ETFs can provide investors with a diversified portfolio and low fees, there are some disadvantages to consider. One of the main drawbacks of passive investing is the inability to capitalize on market inefficiencies. With a passive strategy, investors rely on broad…

Read complete post here:
Source link