How to maintain a healthy mix of active and passive mutual funds in your portfolio

For that, we first need to know how active funds perform in different market segments these days.

Different market segments and alpha potentials

Over the last few years, it is becoming clear that the majority of active large-cap funds are finding it difficult to outperform the Nifty 50 or Sensex consistently. I must mention here that this is not just an Indian thing, but is the case with most major markets. As markets mature and become more efficient, the avenues to generate alpha keep shrinking. And this is exactly what is happening here now in the large-cap space. More so since SEBI tightened the definition/guidelines for different fund categories a few years back.

Due to lack of outperformance, many feel (and they aren’t wrong) that there is not much sense in going with active funds for large-cap exposure.

That was about large-caps. But what about mid and small-cap funds and their returns?

While there will always be funds that do worse than their respective index, there is still a lot of scope for alpha generation in the mid & small-cap space. Quite a few active funds in the space are doing very well compared to indexes consistently.

Over time, it’s possible that the increasing maturity of Indian markets and the efficient price discovery will reduce the outperformance of active funds in this space. But that day is still not here like it is for the large-caps.

Picking active and passive funds

For large-cap exposure: Choose passive large-cap index funds based on Nifty 50 or Sensex. Aggressive investors can also consider the Nifty Next 50 index fund.

For mid-cap exposure: Pick proven, well-managed, active mid-cap funds. But this in no way means that passive options in the mid-cap space are bad. However, the potential for alpha generation in this space is higher. So, I think one can take the active route as it justifies the cost with the potential to outperform the index.

For small-cap exposure: It might sound odd, but most investors don’t need small-cap funds. To know why, read what I wrote in financial products to avoid.

Passive index funds/ETFs are better options when you need international markets’ exposure. Nowadays, there is a race to launch new exotic passive funds focusing on different countries. But most investors only need 1-2 international funds. That too having a US-based index fund is good enough. Only if you are an aggressive investor who wants some tactical country-specific bet, should you invest in non-US funds.

Allocating between active and passive funds

Pick passive index funds for large cap and use active funds for investing in mid-small caps (and to have flexibility via flexi-cap or balanced advantage funds).

There is no one right formula to determine the allocation between the two but here are a few pointers:

-If you are a conservative investor who wants a small equity exposure, then just pick index funds. No need for active funds. The large-cap universe is good enough for your small equity allocation.

-If you are a balanced investor, use passive large-cap index funds as core and active funds (for mid-small cap exposure) as a smaller satellite of a core-satellite portfolio.

-If you are an aggressive and active investor, keep active funds as core and index funds as the satellite part of your portfolio.

A good strategy can have both active and passive funds co-existing in your MF portfolio. That way, you get the best of both worlds.