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Here's how to build a passive-only portfolio using Index Funds and ETFs

Index funds and ETFs both are good options for passive investing. Although ETFs have lower expense ratios than index funds, at times, lack of liquidity can lead to poor pricing of units.

June 09, 2022 / 08:15 AM IST

Can you build a low-maintenance, passive portfolio in India, that is made up entirely of index funds and Exchange-Traded Funds (ETFs)?

Yes, you can. Passive investing is gaining momentum and there are now many options for investors.

So how to go about building a passive-only portfolio?

As I said, there are several passive index options ranging from market-cap-based indices like Nifty50, Sensex, Nifty Next 50 and Nifty Midcap 150 to new factor-based indices (Value, Momentum, Quality, Low Volatility and so on).

But you don’t need all of them in your portfolio.

Just having 3-4 passive instruments is enough to build a solid, low-cost, low-maintenance investment portfolio. So don’t let the ever-increasing menu of passive products in India confuse you.

Here is what to do:

Large Cap Index Funds or ETFs

Unless you are a professional investor who knows what he or she is up to, you should always have a major chunk of your holding in large caps. And for that, you can choose between Nifty50 or Sensex-based index funds. If a little volatility is acceptable to you as a tradeoff for slightly higher returns, then you can combine one of the above funds with a Nifty Next50 index fund as well.

Also read: Is investing in index funds best way to take large-cap exposure?

Mid-Cap Index Funds & ETFs

Midcaps can be volatile but can also give higher returns in the longer run. For midcaps, the passive options are Nifty Midcap 150 and Nifty Midcap 50. Another option, which is based on a factor index, is Nifty Midcap 150 Quality 50. Although the broader Nifty Midcap150 seems like a better option given the higher risk profile of midcaps, the smaller 50-stock factor-passives are also fine although factor investing is still new in India and hence, untested.

But unlike large caps where active fund managers are having a tough time, the mid-cap space in India is still not that efficient and hence, some of the better active midcap fund managers are still able to do pretty well compared to the indexes. So, in my view, unless you have really decided to take the pure passive route, it may be a good idea to pick from well-managed and proven active midcap funds.

Small-Cap Passive Funds & ETFs

Most investors do not need to invest in small-cap funds. This is my view and many others may not subscribe to it. But small-cap funds (active or passive) are part of avoidable investment products, in my view.

International Index Funds & ETFs 

After Indian equities, you can consider investing in international markets via index funds too. For most investors, having a US-based S&P500 index fund (or NASDAQ-based if you are willing to accept more risk and volatility) is sufficient as it provides good exposure to developed markets.

Sectoral / Thematic Index Funds & ETFs 

Not needed. Most investors are better off investing in broad, diversified indexes and don’t need to take sectoral bets.

Factor-based Index Funds

Factor investing has caught the fancy of investors recently. In back-testing, several factors do seem to work and generate alpha. But in any given year, not all factors may work simultaneously. So, may be, to avoid a scenario of being stuck with a single factor underperforming, there is a case to create a multi-factor portfolio to stabilize outcomes in the short term as well. But then again, all the data for these strategies is just back-tested and hence, there is a lack of a sufficiently long track record and data. Hence, best to ignore these for the time being or limit exposure to them.

How much weightage to give to different indexes?

There is no one right answer here. And it will depend on an investor’s risk appetite, age, goal timelines and portfolio aim.

But assuming that we are only considering equity here, and debt allocation is already managed by the investor via options like Employees’ Provident Fund, Public Provident Fund, bonds, debt funds, and so on, here are a few possible combinations for a passive-only portfolio:

  • 100% in Nifty50

  • 50-70% in Nifty50 + 30-50% in Nifty Next50

  • 50% in Nifty50 + 25% in Next50 + 25% in Midcap50/150

  • 80% in Nifty50 + 20% in S&P500/Nasdaq

  • 40% in Nifty50 + 25% in Next50 + 25% in Midcap50/150 + 10% in S&P500/Nasdaq

Also read: How to mix Active & Passive funds to build your MF portfolio

Which is better -- Index funds vs ETFs?

Both are good options for passive investing. Although ETFs have even lower expense ratios compared to index funds, at times lack of live liquidity can lead to poor pricing of units. Also, ETFs have additional trading, brokerage and demat costs that most people ignore. But in general, both are good options although large investors can take the ETF route.
Dev Ashish is a SEBI Registered Investment Advisor (RIA) and Founder, StableInvestor
first published: Jun 9, 2022 08:15 am