Avoiding active funds? Here’s how to build an all-passive mutual funds portfolio

When you invest in mutual funds, you have the option to choose from passive funds (which replicate existing indexes without the fund manager’s intervention); or go for active funds (where the fund manager decides where to invest).

While there are merits and demerits of both, often investors choose one side and then become quite vocal supporters of the chosen side (on social media).

But without doubt, passive investing is definitely gaining a lot of traction in India now. This trend has already been there in developed markets for several years. Till a few years back, there were just a handful of passive options in India. But now, there are more than a hundred passive schemes to choose from.

So, if for some reason, you decide to go passive-only, then how can you build an all-passive mutual fund portfolio made up only of index funds?

To give structure to this discussion, let’s go market segment wise:

Large-Cap Index Funds

These are indexes which invest in the top-100 stocks by marketcap. Most investors will do well to have some component of largecaps in their portfolio. And the best option for them in the passive space is to choose a largecap index fund which is based on Nifty50 / Sensex / Nifty100. Index funds based on these indices provide sufficiently diverse exposure to largecap stocks.

Also, while Nifty Next50 also technically qualifies as a largecap index (since it is part of top-100 stocks by marketcap as per SEBI definitions), in reality, it has all the characteristics (risk-return attributes) of the more volatile cousin midcaps. So, if a little extra volatility is acceptable to the investor, then one can even consider the Nifty Next50 index fund in addition to larger ones based on Nifty50/ Sensex/ Nifty100.

Mid-Cap Index Funds

Midcaps are those stocks which are part of the marketcap range bucket of 100-250. These are comparatively more volatile than the largecaps but also have the potential for higher returns in the longer run. In midcaps, the available passive index options are Nifty Midcap150, Nifty Midcap50 and the factor-based Nifty Midcap150-Quality50.

Nowadays, there is a passive option that combines largecaps and midcaps. This is the newly launched index of the Nifty LargeMidcap 250 index.

Small-Cap Index Funds

The smallcaps have given amazing returns in the last few years and hence, these are darlings of many. Even here, there are passive options though active funds rule the roost. Nevertheless, in smallcaps, the available passive index options are Nifty Smallcap250, Nifty Smallcap50 and the factor-based Nifty Smallcap250-Quality50.

That was about the three core marketcap categories and the available passive investment options in them.

But what I am about to say now may not be liked by fans of passive investing. But please bear with me. Unlike largecaps where nowadays the active fund managers are finding it difficult to beat the index TRI returns, the Indian mid-and-smallcap space is still not very efficient. As a result, good active fund managers in this space tend to do quite well compared to the indexes and generally beat them.

Hence, in my view (if you were to hear it), unless you have taken a blanket decision to avoid active funds, it would be a good idea that in a portfolio of largecap index funds, you add well-managed and proven active midcap and smallcap funds.

And what about other categories?

Say, what about sectoral/thematic index funds?

In my view, most investors can skip sectoral/thematic funds altogether. Most people don’t have sectoral expertise to understand when to enter and exit such funds. So better to avoid them and just invest in broader, well-diversified indexes.

For exposure to stocks outside India, one could have considered having a US-based S&P500 index fund (or a NASDAQ-based Index Fund if willing to take more risk and volatility). But with RBI’s limitations, most of the funds are currently closed for subscription anyways.

To build an all-passive portfolio, just having 2-4 funds is enough. Of course, the AMCs will keep launching more and more passive options to gather AUM. But you don’t need to invest in most of them. Just stick to 2-4 schemes and you can easily build a solid, low-cost, low maintenance pure passive mutual fund portfolio.

How much to allocate to different indexes?

If we are looking at suggestions for equity funds in the passive fund, then here are a few possible combinations:

• 100% in Nifty50 index only
• 60-70% in Nifty50 index + 30-40% in Nifty Next50 index
• 50% in Nifty50 index + 25-30% in Nifty Next50 index + 20-25% in Nifty Midcap150 index.

Dev Ashish is a Sebi-registered investment adviser and the founder of Stable Investor