Weigh Your Options Before Going Passive On Mid- and Small-cap Equity Funds

The new fund offer (NFO) of Nippon India Nifty Smallcap 250 Index Fund is underway at present. With the launch of this fund, six passive products (index funds and exchange traded funds or ETFs) are now available in the mid- and small-cap segments. After years of underperformance by the majority of large-cap active funds against their benchmarks, many financial advisors now suggest that investors should have either 100 per cent, or at least 50 per cent, exposure to passive funds in this segment. But such a consensus does not prevail when it comes to passive funds in the mid- and small-cap segments, one reason being that not enough passive products were available here until recently.

Let us examine the arguments for and against opting for passive funds in the mid- and the small-cap categories.

1. Get Market-equivalent Returns

A key reason for investing in passive funds in any segment is that the investor is assured of market-equivalent return. The latest S&P Indices Versus Active Funds (SPIVA) scorecard that is available is for year-end 2019 and it shows that only 40.91 per cent of mid- and small-cap funds were outperformed by their index (compared to 82.9 per cent of large-cap funds) over the five-year period. Proponents of passive funds, however, argue that even though data shows that the majority of active funds in the mid- and the small-cap categories managed to outperform the benchmark, there is no guarantee that the active fund you have chosen will necessarily beat the index (your fund could be part of the 41 per cent that didn’t).

Predicting in advance which active funds (from the many available) will beat their benchmarks over the next 10-15 years is almost impossible. "The funds that outperform in the future may be different from the ones that have outperformed in the past. Selecting the outperformers of the future is not easy," says Pratik Oswal, head of passive funds, Motilal Oswal Asset Management.

Conservative investors, whose aim is to just earn market-equivalent returns, will be better off in a passive fund. "By selecting a passive fund, you remove the non-systematic risks like stock picking and fund manager selection," says Vishal Jain, Head ETF, Nippon Life India Asset Management.

When an investor selects a passive fund, he does not need to monitor performance that closely (except occasionally to ensure that the tracking error of his fund/ETF is not higher than that of peers). This means the investor in a passive fund does not have to switch funds due to deterioration in performance (as happens often in the case of active funds). "You can stick to the same fund or ETF for 10-20 years or longer and benefit from the India growth story," says Jain. Portfolio management becomes easier—investors just need to focus on maintaining the right allocation to various asset and sub-asset classes through periodic rebalancing.

The much lower expense ratios of passive products also work in their favour, especially over the long term.

Experts also suggest that when making the active-passive comparison, one should compare not just the returns but also the risk that fund managers take to generate outperformance. A measure of risk-adjusted return, like the Sharpe ratio, should be used instead of just comparing returns.

For many investors, who have just entered the markets and have small portfolios, it may not be worthwhile to pay the fee of an investment advisor. "It is difficult for newcomers to select the right active fund. It is simpler for such new-to-the-markets, do-it-yourself investors to go with a passive fund," says Oswal.

2. Majority Of Active Funds Outperform

Active fund managers say their track record in the mid- and the small-cap segments speaks for itself. "Data shows that over 90 per cent of mid-cap active funds and approximately 80 per cent of small-cap active funds have beaten their benchmarks over the past five years.

Therefore, I feel it would be premature at present to look at passive funds in the mid- and small-cap categories," says Vinit Sambre, head of equities, DSP Mutual Fund.

These two categories are also riskier. "Studies have shown that there is a four-five times higher probability of a mid-cap stock becoming a small-cap stock, than of a mid-cap stock becoming a mega-cap stock. In other words, there are potentially more losers than winners in these categories and hence you could lose money if you invest in the wrong stock," says Sambre. Therefore, he feels that it is important to go with a fund manager who has demonstrated an ability to eliminate the losers and pick the winners.

Fewer analysts track stocks in the mid- and the small-cap segments. “Information asymmetry still seems to exist in these segments. Deep research could throw up opportunities for active managers, enabling them to outperform their benchmarks. Until that changes, it may be a good idea to use active funds in these categories,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

3. Will tracking error be low?

Most of the passive funds in the mid- and the small-cap categories have been in existence for only a short period. “Adequate record does not exist to demonstrate that passive fund managers can run funds with very low tracking errors, especially in the small-cap segment,” says Dhawan. Many stocks within the small-cap segment have low liquidity, and this could possibly pose a problem for passive fund managers.

Fund managers, however, are confident they can handle this issue. "We have been running an index fund in the small-cap category for the past year and it only lags the index by a small margin. Remember that the stocks that have the highest weight in the index are also the most liquid. The illiquid ones have a very small weight," says Oswal.

What Should You Do?

Above, we have laid out the arguments for and against taking the passive route in the mid-and small-cap space. After carefully weighing their merit, investors could exercise one of the following options.

One, since the majority of active funds are outperforming at present, they could stick to these funds for the present.

Two, a conservative investor could decide that he does not want to take fund-manager risk. In that case, he may opt for passive funds. He could allocate either 100 per cent to passive funds or split his allocation between active and passive.

Three, an investor who buys into the argument that adequate data on tracking error is not available may defer his decision. “Investors also have the option to take passive exposure to the mid- and small-cap segments via a Nifty 500 based index fund. This broader index with a substantial large-cap component is likely to have a smaller tracking error than a pure mid- or small-cap fund,” says Dhawan.

While making the decision, investors should take into account their own risk appetite—whether they will be happy with market-equivalent returns or would like to take the higher risk of betting on an active fund in anticipation of higher returns.