News Analysis

Decoding the pros and cons of investing in ETFs vs actively managed funds

Sundeep Sikka | Updated on November 20, 2019

Like all other decisions in life, investing too can often be marred by emotional choices and psychological banners. So, it is not necessary that only layman investors can take biased calls. For that matter, even fund managers are subject to it. Hence, emerges the prolonged and intense debate — Whether one should rely on ETFs which are passively managed or actively managed funds? Both the investing strategies have their distinct pros and cons. Today, let us analyse both these techniques and also evaluate if they can co-exist in a portfolio.

What is active investing?

As the name suggests, active investing is all about making investment decisions actively. It is employed by in an attempt to beat the market returns as represented by an appropriate benchmark index.

As such, it amounts to buying or selling individual stocks which depend upon fundamentals, financial position and also the perception regarding the stock prices. The core idea behind active investing is to take benefits of the valuation gaps as prevailing in the market and as may be justified by the fundamentals of the company.

Thus, the basic premise is to capitalise on market inefficiencies’ or pricing anomalies. The decision involves outstanding research, analysis of market trends and conditions, timing, sector calls and so on. However, predicting future market movements or stock prices on a continuous basis is just not possible.

Further, news and future events that are at times unpredictable and random, drive the stock price. This simple logic makes it impossible for any human being to actively pick stocks/ managers/ sectors that may consistently outperform the average market. New events/ information that moves the stock prices incorporate into the market price of security within minutes. Thus, whatever is known by market participants is instantly discounted in the current market price.

Since this is not an easy task, active investors often retain the services and expertise of professional fund managers by investing in actively managed mutual funds. Fund managers stay alert about the companies already existing in their portfolio and further, on the companies on the watch list.

What is ETF investing?

Regarding the investment approach, ETF investing, or passive investing as it is commonly known as is precisely opposite to active investing. As such, it tracks the portfolio pattern of underlying indices/ benchmark. For instance, Nifty ETF would own every stock in the NSE Nifty50 in the same proportion as the market index.

Since passive investors need to replicate the benchmark index, the portfolio turnover is minimal depending upon the changes in the benchmark index and thus, have a lower cost structure as compared to active investors regarding annual portfolio management charges, expense ratios, brokerage, transaction costs, etc.

Passive investors tend to have an enduring belief in the power of markets and aim to harness the power of markets via representative portfolios or indices.

Thus a passive investor, by only investing in the market indices, is eliminating the non-systematic risks like stock specific and fund manager risk. The risk is limited to a systematic one, which is common to all methods of investing. While a passive investor reduces his investment risk, he also gives up the chance of generating Alpha, i.e., making better returns than the benchmark.

As markets become more and more competitive, it becomes difficult to locate and capture pricing anomalies.

Therefore, it assumes importance to forego active investment style in such a scenario as there are higher chances of underperforming the market. In the current Indian context, data demonstrates high market efficiency in the large-cap equity segment. Hence allocating assets to passive products is a proven low-cost passive vehicle for implementing the passive investing philosophy. Examples of passive investment products are Gold ETF tracking gold prices, Sensex ETF tracking Sensex movements, Midcap ETF tracking Midcap 100 index, etc.

Is there a mid-way?

Amidst all this analysis, one must be curious if there is any mid-way between the two strategies adopting the benefits of both. It is indeed preferable to select a core and satellite approach for efficient portfolio construction. ETFs can help by providing a diversified exposure within an investment portfolio.

As such, depending on risk appetite and suitability one of the two could form the ‘core’ of your portfolio, and the other could the ‘satellite.’ For instance, in case you have conservative risk appetite, build a core portfolio of ETFs providing a way to reduce the running costs of a portfolio without deviating too much from the benchmark.

It is indeed helpful in stock segments where the alpha returns are lower due to lesser probabilities of valuation mismatch, e.g., large-cap stocks. The remaining part of portfolio ‘satellite’ can be actively managed through investment in selected equities or actively managed assets such as stocks, other MF schemes and sectoral allocation.

The aim can be to generate ‘alpha’ through picking investments that may outperform the core portion of the portfolio. You can balance your risk-reward ratio and get you better returns from the portfolio. In case of a high-risk appetite individual, the opposite may be suitable. In the end, an ideal portfolio is one which captures the best of both worlds.

The author is ED & CEO, Nippon India Mutual Fund

Published on November 20, 2019

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