Too many smart beta funds? Here’s how investors can cut through the passive investing noise

The Indian passive funds space has a problem now: hyper activity. The explosion in the number of passive fund options launched by asset management companies (AMCs) has made the erstwhile quiet corner of passive investing, into something of a noisy park. And while having options is a good thing, this extreme activeness in the passive space is confusing small investors.

Some people may want to put the blame on AMCs for launching too many options. But that is not what the focus is today. Let’s try to make sense of the passive clutter and see if we can identify a few options that are sufficient for most investors.

Large-cap index funds

Best suited for passive

After the Securities and Exchange Board of India tightened the definition for large-cap funds (plus all other categories) and introduced total return index (TRI) benchmarks a few years ago, most active largecap funds have been finding it increasingly difficult to consistently outperform large-cap indices on a rolling-return basis.

Therefore, for most investors’ large-cap requirements, a plain-vanilla Nifty 50 index fund is sufficient. Nifty Next50, though classified as a large-cap index, behaves wildly and has all the traits of mid-small cap in terms of risk and drawdowns. But if one is slightly more aggressive and comfortable with higher risks/volatility in exchange for potentially better returns, adding the Nifty Next50 index fund can also be considered in a small way.

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Or simply, a Nifty 100 fund can give a mix of both though skewed towards Nifty 50 (as Nifty 100 has about 85% weightage of Nifty 50 and only the remaining to Next50)

Mid-caps & small-cap indexes

Don’t rush to go passive

Here’s where things get different. Unlike the large cap space, the mid cap and small cap segment in India isn’t fully efficient yet. Skilled active fund managers consistently beat their benchmarks in this space meaningfully. Hence, it’s best to take the active route in mid-cap and small-cap funds.

But does that mean passive mid-cap funds are bad? Not at all. They’re perfectly fine if index-level returns are acceptable to you. But given how good active fund managers have done in this space, it is suggested to remain active in this space. As for small caps, best to skip the passive small caps category.

Purists may not like what I said above, i.e. mixing passive and active funds to build a resilient, style-and market cap-diversified portfolio. But different market segments have different alpha potentials and hence, they can and should be blended while building a solid portfolio. This is not to say that passive-only portfolios are bad. One can even go for one Nifty 500 index fund to get a broad diversification and be done.

Index examples