<ul><li>In the hotly-contested debate around active versus passively-managed schemes, often many investors miss the woods for the trees.</li><li>The beauty of passive investing is that it does not suffer from any emotional bias, recency bias or any other prejudice that afflicts humans.</li><li>Passive products such as index funds and ETFs are better-suited for tactical allocation in a portfolio. </li></ul> If mutual funds are a cricket team, actively-managed funds would be the star batsmen while passively-managed schemes would be the all-rounders. In the hotly-contested debate around actives versus passives, often, many investors miss the woods for the trees. In a seasoned portfolio, both active and passive products have their respective place because of the inherent design. Yet, the narrative often gets hijacked and becomes a question of either or, instead of deciding the choice of the right product for the right investor. Given the dynamic nature of markets and economic cycles, it is impossible to guess the winning asset class/theme/sector consistently. Furthermore, there may be prolonged cycles of outperformance and underperformance of these investments, and thus difficult to project the winner. So, investors should ideally have a mix of investment plays in their portfolios through active and passive products. While domestic markets have been stuck in a range for quite some time, tactical bets have played out in sectors such as banking, public sector undertaking (PSU), infrastructure and consumption sectors. This has brought to the fore the utility of passive product allocation when used tactically. Here, for tactical plays, one can do it largely through passive products such as thematic/sectoral index funds and ETFs or exchange-traded funds, and core plays through actively-managed diversified funds that can generate better investment outcomes over the long-term. The beauty of passive investing is that it does not suffer from any emotional bias, recency bias or any other prejudice that afflicts humans. Since portfolio construction and maintenance is rule-based, passive products give simple pure-play exposures to sectors/themes at the lowest cost possible. This fits well with the overall tactical allocation principle and dynamic nature of product requirement to exploit short-lived market opportunities. Tactical plays Tactical asset allocation is practised by many investors. This is done by smart shifts in a certain percentage of assets held in various categories to take advantage of strong market sectors/asset classes. Such a strategy allows investors to create extra value by taking advantage of certain situations in the market. Passive products such as index funds and ETFs are better-suited for tactical allocation in a portfolio on account of various reasons as listed below: One, passive products track markets efficiently. There is no time lost in tweaking a portfolio, since indices get rebalanced at defined intervals and positions can be taken quickly. Two, specific themes/sectors often offer a short window of opportunity for tactical allocations. Especially, when it comes to sectoral allocation, timing matters and for this type of allocation one can choose a passive offering. Healthcare as a theme saw a sharp rally during the pandemic years. The S&amp;P BSE Healthcare index delivered 61.45% and 20.87% respectively in calendar years 2020 and 2021. However, come 2022 and 2023 (year-to-date), the index delivered a negative return to the tune of 12.5% and 13% respectively. If an investor had initiated investments in 2020 and held on to it till date, almost half of the gains accumulated till 2021 would have been wiped out. This shows the importance of getting both the entry and the exit right in sectoral/thematic investments. Three, for commodities investing, a savvy investor can consider the ETF route as it efficiently tracks the price of the underlying commodity. So, if an investor is bullish on, say, the outlook of gold or silver, instead of physically buying or storing these commodities, he can just own these in ETF form and enter and exit the position with ease thereby boosting portfolio return. Four, passive smart-beta offerings can be harnessed to play a market trend. If the market is momentum based, one of the easiest ways to participate is through momentum-based smart beta offerings. In this manner, you can participate in the trend without disturbing the core of your long-term portfolio. Similarly, a knowledgeable investor can tactically make use of smart-beta offerings to play a particular style of investing. To conclude, over a complete market cycle, there will be times when active management triumphs and at other times, a passive approach may outperform. An ideal portfolio should be one which captures both these trends. Instead of pitting one strategy against the other, harness the power each of these approaches offer. At all times, use an informed eye to decide when and how much to skew towards passive. If unsure, seek help from a financial advisor. (The writer is the head of investment strategy at ICICI Prudential AMC)<meta content="cms.next" name="cmsei" />

How passive offerings can contribute to tactical allocation of a portfolio

<ul><li>Equal-weight indices give equal weightage to all the stocks making up a benchmark. </li><li>On an equal-weight index, no stock can unduly influence the index movement and all stocks get almost the same representation – making for a fairly well-diversified portfolio. </li><li>When many of the market constituents witness strong rise in stock prices, an equal-weight index can deliver better returns than a concentrated portfolio. </li><li>In an equal-weight index, as a result of the same weightages to all stocks, the level of sector concentration also becomes reduced.</li></ul>Many retail investors would be familiar with regular index investing. This often entails investing in funds that track indices such as the Nifty 50 and the Nifty 100. The stocks that form a part of these indices are given weightages based on free float market capitalisation – we’ll come to it in a bit. Therefore, each stock has a different weightage in the overall index. An interesting variant that has been gaining traction is equal-weight index investing. So, these are indices that accord equal weights to stocks. Here’s more on what goes into equal-weight indices and what you must understand before investing in them. How free-float and equal-weight indices vary As mentioned earlier, the regular Nifty 50 and Nifty 100 indices are based on free-float market capitalisation. Now, there are broadly two categories of shareholders in listed companies. Promoter and promoter groups, and trusts backed by them are one category. Public shareholders form the second type. So, the shares of promoters are not traded actively or are allowed only with many restrictions. The rest of the shares are free float and allowed to be traded in the markets. Now, the free float shares multiplied by the share price gives the free float market capitalisation. While constructing the index, the stocks with higher free-float market capitalisation get higher weightages than those with lower numbers. Equal-weight indices, on the other hand, do away with such restrictions based on free- float market capitalization. These indices give equal weightage to all the stocks making up a benchmark. For example, all stocks get around 2% weightage in the Nifty 50 Equal weight index. In the Nifty 100 Equal Weight index, all stocks are given a weightage of around 1%. Broad-based stock and sector representation Investing in an equal-weight index has its fair share of advantages. Here are a few of those. Truly well-diversified portfolio with same weightages: Let us take the Nifty 50 as an example. The top 10 stocks in the Nifty 50 account for nearly 58% of the portfolio. A few stocks can have a disproportionate impact on the movement of the index. <img src="https://lh4.googleusercontent.com/EQuxFSvIA1pTEgfLWP92ATrWAtkOBUObur3Hzf9MvstjTqe2W1I1nyD0X4wYXOWH-N-S5LdH1FZQMvoPvJ6WyE2ZlZj1Zq7uf8dXpNXDO7cQH4q4_xpqw0SVVWNkb5y9khQZKNMkor_bg2QkZo5Heo6YJGgfMe1j67wUNDSUk-B3Xp0YJhXIRrWe865M9t5cc4IyJ_vCQg" /> <img src="https://lh4.googleusercontent.com/P6GxNV1ugM2QRUiVMxUuRVNwtVnpQcDlor4fXvS_jdHNFVrA-YYLGoxMvR20XoHWbtfl22JleHXFlc2iai3_81yBgm-L5qATnbqWQ0mZYWl9g87XKNE_xc7gMgAaC9fxcBvjWjgkrgYZ0HGnXnhSO_5PdAu159rPS7kyUZ6U6vF8IE38Qa5jrwEkx_ahDEhAYlAXYIumZg" /> In the Nifty 50 Equal Weight index, on the other hand, the top 10 stocks make up only a little over 20% of the portfolio. No stock can unduly influence the index movement and all stocks get almost the same representation, thus making for a fairly well-diversified portfolio. Chances of outperforming in broader market rallies higher: When many of the market constituents start rallying and witness strong rise in stock prices, an equal-weight index can deliver better returns than a concentrated portfolio. In the rally after the Covid-19 crash in March 2020, stocks across segments rallied. Such moves help equal-weight indices as most stocks get to participate in the rally. And in a falling market, they may cushion downsides better as weightage to individual stocks is low (just 2% in the case of Nifty 50 Equal Weight index). In effect, the movements on the upside and downside are tempered. <img src="https://lh5.googleusercontent.com/wjyM0sopoYRciXcsR-qftGaGRBjOPmyxIOB_JnTdjcJLyiDkujyb6hK1VBA1zS-PPfHwVMo0i5GvMUJUD29mOUJQwSrp-F9PnLYIn3FvhwwkuvY0VyKwt4Jzh4Wj8tRuAZ_WX4MjLhg9oZxKFyCsoGQWYnrEsbrCD51LujS1eSVX-3l7LqFTteecx0T9CdVDS4VfJaZv_g" /> In a narrower market rally led by very few stocks, a free-float market capitalization index may perform better. An example would be the markets in 2018-19. Lower sectoral concentration: In the equal-weight index, as a result of the same weightages to all stocks, the level of sector concentration also becomes reduced. For example, the financial services sector gets 34.56% weightage in the Nifty 100 index. But in the Nifty Equal Weight index, the financial services segment constitutes only 22.05%. Therefore, there is a better spread of exposure across sectors and a reduction in concentration in select sectors. This diffusion reduces the risks associated with the portfolio. Also, some sectors such as automobiles get better representation in the equal-weight index than the free-float one. As a natural profit-booking index: In an equal-weight index, the rebalancing of constituents happens once every six months. Therefore, even if any stock rallies heavily during a period, its weightage would be restricted to the original equal-weight index levels. This is akin to taking profits periodically in a systematic way. For a retail investor, the optimal way to invest in an equal-weight index is through an index fund that tracks and replicates, say, the Nifty 50 equal weight index. Such an offering could be a diversifier to the portfolio. To further understand product suitability, it is best to seek help from a financial advisor before investing. (The author is the Head Investment Strategy at ICICI Prudential Asset Management Company) <meta content="cms.next" name="cmsei" />

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