InvestorQ : How and when to use passive investing strategies and is ETF a good way of using passive strategies in the stock markets?
swati Bakhda made post

How and when to use passive investing strategies and is ETF a good way of using passive strategies in the stock markets?

Dia Deshpande answered.
3 years ago

Passive investing is the exact opposite of active strategy. In active strategy, you seek higher returns but in passive strategy, you only seek index returns. Let us look at some types.

Types of Passive Investment Strategies:

There are four ways of creating a passive investment strategy in the Indian context…

· An equity investor can create a passive strategy by buying up all the index stocks in the same proportion as the index. But for an individual that can be quite complicated as he will have to track index changes, weightage changes etc.

· A simpler way to replicate the above will be to directly buy an index fund, which is offered by many mutual funds in India. An index fund buys up the entire index in the same proportion. The fund manager manages the tracking error and ensures that the fund performance is as closely aligned to the index as possible. Index funds can be bought from the mutual fund houses, from distributors or even online.

· ETFs are a slight variation of the index fund. Like an index fund, the ETF also creates a portfolio of index stocks in the same proportion. The only difference is that the ETF is listed on a stock exchange and can be bought and sold on any recognized stock exchange. Additionally, ETFs are also available on other benchmarks like ETFs on gold, ETFs on silver, ETFs on equity indices, ETFs on debt market indices etc.

· There is a slight variation of passive investing which entails buying and holding a portfolio of dividend yield stocks. Dividends are tax-free in the hands of the investor up to a limit of Rs.1 million per year. Thus a stock that offers a dividend yield of 6% will actually be paying a effective tax- adjusted return of {6%/(1-0.3)} = 8.57%

When to adopt Passive Investment Strategies

It is hard to pinpoint factors that will make passive investing attractive. But here are 5 situations that can be specifically conducive for passive investing…

· Passive strategies work well when the markets are extremely volatile. In such situations, stock specific strategies are fraught with risk as the downside risk could be quite high. An indexing approach tends to mitigate this overall risk in investing. Passive can work better in such circumstances.

· Passive works better when the markets are being increasingly driven by macro factors and less by micro factors. Take the case of a situation when there are major macro risks to the market like war, interest rate hikes, spike in inflation etc. In such circumstances, the macros will become more important than micros and a passive strategy will work better.

· When most stocks are either fully priced or overpriced in historical terms, a passive strategy works better. In this kind of situation, identifying stocks which can really give you excess returns is very difficult. You will be better off sticking to an index fund since you get the benefit of equities without taking stock-specific risk.

· When the incremental returns on active funds is very small. For example if index funds are giving 12% and active funds are giving 16%, then there is a case for active funds. If the active fund in the above case if just giving 13%, then the higher cost and risk is not justified by 1% additional returns. You are better off with passive investing.

· Lastly, when the equity market is more about risk minimization rather than about return maximization. When markets are at their bottom, the focus will be on maximising returns. However, when the markets are at the peak or when they are lacklustre, the focus should be on minimizing risk. In such cases, passive investing is a much better strategy.

How ETFs can generate Alpha at the lowest cost

The big difference between an index fund and an ETF if that you have a much wider choice in case of an ETF. You can have index funds that are linked to gold, to equity indices, to debt market indices and also to global benchmarks. Many mutual funds offer ETFs that are linked to global assets and global indices. Here are five ways to generate alpha using ETFs…

· The first approach is called a smart-beta approach. Here the ETF is benchmarked to a modified index where the tweaks are done to take a small risk and make a bigger bet on a particular theme or story. This risk should be manageable.

· ETFs generate alpha through a process called cash drag. When you operate a mutual fund, you need to maintain certain minimum cash in your portfolio. Since ETFs do not entail redemption pressure and can be sold and bought in the secondary market, the fund needs to maintain less in the form of liquidity. That enhances effective returns on an ETF.

· Thirdly, ETFs encourage large HNI investors and institutions to engage in arbitrage when the NAV of the Fund and the ETF price diverge. This ensures that the two are in sync to the extent possible. This is a big advantage over closed ended funds, which quote at a huge discount to their NAVs.

· ETFs can be used for multiple levels of diversification. Assume that you are holding an ETF on the Nifty and the index is at risk due to macro risks. It is possible to diversify that risk by buying an ETF on gold or an ETF on a global index that is negative correlated with India.

Over the last few years, passive investing has been picking up globally. The AUMs of passive funds like ETFs and index funds are growing rapidly compared to active funds and hedge funds. In India, however, there is still substantial scope for alpha generation through stock selection. However investors need to actively look at indexing as an option.