Active funds are increasingly ceding grounds to passive funds across the world. The trend is also catching up in India.
There are various reasons behind the shift. The most important among them are -- lower costs associated with passive investing and there being no clear proof that active fund managers are able to consistently beat benchmark indices.
But, there's also another side to passive investing that you should be aware of. In this article, we will take a look at the various risks associated with passive funds.
Portfolio concentration
Diversification helps investors in managing risks and reducing the volatility of the overall portfolio. This may not be possible for many index funds. It is because most indices are made up of only top stocks and sectors.
This leads to concentration risk, i.e., investments getting limited to a select few stocks.
Such concentration has become more prevalent in recent years, with select stocks in the indices rallying and the rest flatlining. For example, the weightage of the top five stocks in the Nifty is up from 39% in November 2018 to 42% in December 2020 with RIL and HDFC Bank having weightages of over 10%.
While a concentrated portfolio can reward well when these stocks do well, there is an equal risk of the portfolio going down with poor performances of only a few stocks.
Governance risks
The long-term returns on your investments depend on the quality of the companies you're holding in your portfolio.
Quality of companies depend on various factors like the strength of balance sheet, corporate governance, capital ratios and resilience to competition.
The problem with indices is that they do not take all these factors into consideration while choosing their constituents.
As index funds are mandated to follow their respective market indices, they too have to ignore several factors when investing in stocks. Even if they are not comfortable with the corporate governance standards of a particular constituent of the index, they will have invest in the stock.
Companies like Yes Bank, Unitech, Satyam Computers and Reliance Communications have shown that being part of the benchmark indices does not guarantee good performance and high governance standards.
Tracking error
Tracking error is the difference between an investment portfolio’s returns and the index it mimics or tries to beat.
Every passive fund has tracking error and this a big disadvantage of such funds. This means that the funds do not generate returns proportional to the change in the level of the indices they follow.
Tracking error is a result of factors such as fees and expenses of the scheme, cash flow due to large subscriptions and redemptions, brokerage costs and securities transaction tax, corporate actions like dividend distribution, among others.
Liquidity risks
ETFs are more prone to such risks as they can only be bought and sold on the exchanges. You would be able to sell only if there is enough demand and that may not always be the case.
Index funds too face liquidity risks but in a different way. This is because not all indices are completely made up of popular stocks. Passive funds that track indices with low value and lower volume stocks face liquidity risks.
Still a good investment option
Despite all these shortcomings, passive funds are good investment options. They are cheaper, less complex, and often produce good returns.
Then there's no proof that active funds consistently deliver returns that are higher than benchmarks’ performances. At least with passive funds, there’s a surety that returns will be more or less similar to the performance of the indices.
This explains the rising interest in passive funds globally.
