How Some Funds Can Deliver 'Active' Returns Passively!

In the world of investing, a fundamental debate often occurs in investors' minds about whether to invest in active vs passive funds. Both these two options have their own advantages. While active funds seek to outperform the market with the expertise, research, and timing capabilities of fund managers, this is reflected in their higher costs. In contrast, passive funds track a market index, offering investors broad exposure to the market at lower costs, but the return potential is below that of active funds.

However, the recent evolution in the passive space has given rise to a new category of funds promising to deliver "active" returns through a structured passive approach.​ These are often referred to as smart beta or factor-based index funds, and they represent a compelling middle ground for investors. In this article, we will explore some passive funds that can deliver active returns.

How can Passive Funds outperform

For the large majority of investors, earning alpha returns over and above the broader market is the ultimate investment objective. Historically, that quest for alpha returns has directed investors toward actively managed funds, where skilled fund managers select stocks to buy and sell, as well as the timing, and implement complicated investment strategies.

While some active funds do manage to outperform the market consistently over time, over the long term, it's tough to do so for all active funds. Thus, the higher expense ratios of active management can substantially reduce long-term gains.

On the other hand, passive investment offers diversification and market-level returns at low cost by investing in traditional index funds or exchange-traded funds tracking benchmarks such as the Nifty 50. Passive funds are not expected to outperform the market; they will replicate the performance of the index to provide investors with a reliable investment avenue.

This innovative concept, where the demand of investors seeking aggressive returns has become feasible with a low expense ratio, gave rise to factor-based index passive funds attempting to bridge this gap with passive management targeting specific market factors conventionally associated with outperformance to deliver higher returns.

For example, Nifty Alpha 50 index funds invest in those 50 Indian stocks out of the top 300 listed ones, which have demonstrated the highest "alpha" returns, i.e., excess returns against their benchmark in the past year. Passive funds like these provide diversified exposure to companies that generate alpha returns and are suitable for investors looking for momentum-driven, high-growth opportunities.

The Role of Factor-Based Indexing

Smart beta, or factor-based indexing, involves a systematic investment strategy that aims to capture specific risk premiums or "factors" that have a proven track of driving excessive returns. Instead of weighting stocks simply by market capitalisation, as traditional passive funds would do, this new approach picks and weighs stocks based on a set of predefined factors.

These factors are chosen after extensive research demonstrating their ability to generate superior returns over long periods. Some common factors include:

• Value: Invest in those stocks that are undervalued but have strong fundamental metrics. For example, the Nifty 500 Value 50 Index Funds target the 50 most undervalued companies within the Nifty 500 universe.
• Momentum: Investing in stocks that have exhibited strong performance trends over recent periods. For example, the Nifty 500 Momentum 50 Index Funds. It follows the broader Nifty 500 index but selects only 50 stocks.
• Quality: Invest in stocks with solid balance sheets, stable earnings, and low debt.
• Low Volatility: Invest in stocks that exhibit lower price fluctuations.
• Size: Invest in small-cap companies with potential to deliver high growth.

By systematically tilting a portfolio towards these factors, these passively managed funds attempt to achieve returns delivered by active management funds, but without the higher expense ratios, human biases, and inconsistent performance.

Why Choosing a Hybrid Approach Is Beneficial?

This hybrid approach offers several benefits to investors, such as:

• Lower Costs: Similar to traditional passive funds, the expense ratios of these factor-based index funds are lower than those of actively managed funds, as they do not have large research teams and frequent trading decisions by fund managers.
• Transparency: The detailed methodology of selecting and weighting stocks is publicly available; thus, investors have complete transparency and know what they are investing in.
• Reduced Human Bias: The rules-based nature of these funds removes the emotional decision-making and biases.
• Diversification: While focused on a factor, these funds invest in a basket of stocks, hence offering diversification within that factor exposure.
• Potential to Outperform: By systematically capturing risk premiums that have historically rewarded investors, these funds offer the potential to outperform traditional market-cap weighted indices over the long term.

Conclusion

For investors seeking more than the average market return but wary of the costs and inconsistencies of active management, factor-based index funds offer an interesting alternative. By passively tracking indices, these funds uniquely pursue "active" returns.

This new niche in the investment landscape is a smart, cost-effective, disciplined avenue through which investors can supercharge their portfolios, without the extensive oversight and hefty fees in traditional active funds. Investing strategies are likely to continue changing, with these passively managed, actively seeking returns funds playing a very significant role in enabling investors to achieve their goals.