How passive offerings can contribute to tactical allocation of a portfolio

• In the hotly-contested debate around active versus passively-managed schemes, often many investors miss the woods for the trees.
• The beauty of passive investing is that it does not suffer from any emotional bias, recency bias or any other prejudice that afflicts humans.
• Passive products such as index funds and ETFs are better-suited for tactical allocation in a portfolio.
  

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&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)