Active learning about Passive Investing - Network FP
August 8, 2019

Active learning about Passive Investing

Chintan Haria
Vice President ICICI Prudential Asset Management Company Limited

Active learning about Passive Investing

Disclaimer: The information contained herein is solely for private circulation for reading/understanding of registered Advisors/Distributors and should not be circulated to investors/prospective investors.

Passive Investments

Indexing refers to passively investing in all the constituents of an Index and replicating the Performance of the index as closely as possible.

1Various vehicles available for Indexing in India

Index Funds

“The index fund is a sensible, serviceable method for obtaining the market’s rate of return with absolutely no effort and minimal expense. Index funds eliminate the risks of individual stocks, market sectors and manager selection, leaving only stock market risk. – John Bogle

ETFs

ETFs are similar to index funds and are actively traded on the exchange. Following are a few types of ETFs available in India:

  • Equity ETFs
  • Debt ETF
  • Commodity ETFs

Like an index fund…

  • Tracks an index
  • Open ended mutual fund scheme
  • Lower expense ratio compared to actively managed schemes
  • Lower turnover and higher transparency as compared to actively managed schemes

Like a stock…

  1. Intraday trading on the exchange
  2. Real time prices
  3. Put limit orders
  4. Minimum trading lot – 1 unit
  5. Delivery into your Demat account

Concept of Smart Beta ETFs

Smart Beta ETFs combine both Passive and Active fund management strategies.

Smart beta seeks to move away from market capitalisation- based weighing patterns.

Smart beta seeks to improve returns, reduce risks and enhance diversification by investing in single factors like Volatility, Value etc. or multiple factors i.e. combination of the aforementioned factors.

2

P/E – Price to Earning Ratio

 P/B- Price to Book Ratio

 EV/EVIBTA – Enterprise value / Earnings before Interest Tax Depreciation and amortization

 ROIC – Return on Invested Capital.

 The above list of factors is illustrative and not exhaustive.

Assigning weights the Smart Way

Usually assign weights using full market capitalisation method like Nifty 50 Index. Higher the market cap of stocks, higher is the weightage of such stocks

Smart Beta Indices assign weight based on relevant factors. For e.g. Low Volatility index assigns weight based on the below formula:

 Weight = [(1/ Volatility)/ sum (1/ Volatility)

3

Data as on April 30,2019. Source:Niftyindices.com.

Passive investing as a part of overall portfolio

  • Passive investing allows investors to take exposure to all the constituents in the underlying index and diversify their portfolio
  • Passive Funds follow a predetermined strategy irrespective of the market dynamics which limits the overall churn of the portfolio
  • No emphasis has to be laid on the past performance of the passive fund as it tracks the underlying index
  • It has been witnessed that passive investing has generally done well over a long period of time
  • A meaningful allocation towards passive funds will help investors generate closer to market returns for such allocation along with the return generated by allocation to Active Funds

Some Common Queries on Index Funds/ETFs

Index Funds/ETFs flourished in USA in a backdrop of persistent underperformance of active fund. That condition is still not prevailing in India. What is the current sentiment among investors in India about passive investing?

In India less than 1.5% of the total population invests in Mutual Funds. Passive Funds including Index & ETFs contribute approx. 6% to the total AUM (approx. Rs. 25 lakh crores) of all the Mutual Funds in India. The majority of passive fund i.e. Index Funds and ETFs launched in India replicate the broad market indices i.e. Nifty 50.

The recent scheme categorisation circular has made it difficult for active funds to outperform the total return based benchmark indices. Most of the recent data showcase that index funds outperform passive funds by a good percentage. Due to a limited list of passive funds and lack of investor awareness about index funds/ETFs, most Indian investors do not hold passive funds. This space is hugely dominated by HNIs, Retirement Funds and Insurance Companies.

How do smart beta ETFs function?

Most of the smart beta ETFs launched in India have their universe as large cap index i.e. Nifty, Sensex or Nifty 100.The smart beta ETFs are factor based ETFs which include value, momentum, quality, volatility. The smart beta ETFs filter the entire large cap index based on each of the above discussed factors. The smart beta portfolios add certain quantitative filters which allow investors to allocate funds in strategy based companies. As these factors are influenced by various economic and market cycles the returns of smart beta ETF’s are cyclical in nature.

Are there any ETFs which track the Midcap and small cap indices?

There are Midcap based ETFs launched by a few AMCs which cover all midcap companies. A select midcap based ETF is launched to allow investors to invest in top 30 companies by market capitalisation. On the small cap space there is no dedicated scheme launched by any of the AMCs, however to participate across market caps i.e. largecap, midcap & small cap investors can invest in S&P BSE 500 ETF which invest in 500 listed companies on BSE.

As an IFA why should I sell ETFs?

ETFs are low cost passive strategies; hence they can be used as a strategy to acquire new clients. ETFs are a right fit for the client over longer time horizons. Smart beta ETFs are best suited for investors as they are factor based ETFs.

How can smart beta ETF’s be used in tactical asset allocation?

Smart beta ETFs are strategic ETFs which take into consideration various quantitative parameters. As these parameters perform differently in each market cycle, investing in smart beta ETF’s will allow diversification and add returns to the portfolio.

Are ETFs liquid? How much is the discount between the price at which they are sold and the NAV?

 It’s normally said that the price quotes at a discount to the NAV.

ETFs are listed and traded on the stock exchanges making them more liquid in nature. The price discovery of the ETFs is based on the change in price of the underlying index constituents. The market marker/Authorised Participant creates liquidity on the market by providing two way quotes. The gap between the bid/ask price is very limited. A real time NAV during market hours is always published on the AMCs website. There can be a difference in NAV of the ETFs and closing price of underlying index due to tracking error (expense, dividend etc.)

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

 


3 Thoughts to “Active learning about Passive Investing”

  1. Rahul says:

    Nice article providing good foundational and functional knowledge of ETFs.

  2. Sunil Date says:

    We progress from actively managed funds ( Large cap, multicap, Diversified etc) to Index funds & ETF and then progress back to actively managed ETFs ( Smart beta) / Active index fund ( MO had a fund which repliacted the stocks of the index but with Fund manager designed weightages). Cyclic behavior.

  3. Sandeep says:

    Very detailed and timely article and without any bias. To me it is one of the bricks in the blocks of financial planning.

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