Investing only in stable-income products such as fixed deposits cannot help you accumulate enough money to achieve your life goals, for such investments earn low post-tax returns. Realising this, a reader of this column decided to invest in equities for the first time. He wanted to know if an index fund is less risky than an active fund. In this article, we explain why a comparison between the two may not lead to a precise answer. We also offer two principles that you can apply when choosing between these funds for your goal-based portfolios.

Active risk

For the purpose of our discussion, we assume that you will either invest in a Nifty 50 Index fund or an active fund benchmarked to the Nifty 50 Index.

An index fund exposes you to market risks. An active fund exposes you to active risks in addition to the market risks. Suffice it to know that a portfolio manager expects to generate higher-than-benchmark returns, called alpha, by taking active bets on stocks. The risk is that stocks need not perform according to the portfolio manager’s expectations. So, the active fund could underperform its benchmark — that is called active risk. This risk, when it materialises, results in negative alpha.

That brings us to the question posed by our reader. True, you are subject to additional risks if you buy an active fund. But the active risk will necessarily have a positive or a negative outcome. This is because all active funds bet on stocks in an attempt to generate alpha. Some will fail and others will succeed. Remember, risk is the possibility of suffering an adverse outcome (negative alpha for active funds) in the future. So, the question is not whether active funds will suffer adverse outcome, but which funds will.

The argument is different for an index fund. If the index declines/rises, all index funds will suffer an adverse/positive outcome. But the Nifty 50 Index can either rise or decline. So, you may or may not suffer an adverse outcome if you buy an index fund. Importantly, you are not exposing yourself to additional risk by choosing one index fund over another.

For a given period, a Nifty Index fund may generate 11 per cent returns, and an active fund, only 10 per cent. Yet, there will be some active funds generating, say, 13-14 per cent. That means, buying an active fund could either reduce or increase your portfolio risk. And that depends on the fund you choose.

Active principles

So, should you buy an index fund or an active fund? We discuss two simple principles you should apply when choosing between index and active equity funds. But first to the overarching rule. You should choose an active fund only if you are confident that the fund can generate alpha during the time horizon for your life goal.

The first principle is that you should preferably choose an active fund for your less-priority goals, and index funds for your high-priority goals. Remember, you are exposed to active risk, and the adverse outcome could materialise, harming your goals. This is true even if you are confident about your fund-selection process because it requires as much luck as skill to choose the ‘right’ fund. Do you want to achieve your high-priority goals or try your luck at generating alpha?

The second principle is that you could choose active funds in the initial years of your investment, and switch to an index fund 15 years prior to your retirement. This is because you will typically cut your equity exposure to reduce risk as you approach retirement. The argument is that the positive alpha you can earn by investing in an active fund may not be substantial given the lower equity allocation as you approach retirement. Yet, the negative alpha could hurt you.

The writer is founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in

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