What percentage should I allocate to index funds and active funds in my portfolio?
- Ravichandran Kulandaivelu
Index funds have built up an investment case for themselves on the back of their ultra-low expenses and also because in recent years, a majority of actively managed large-cap funds have not been able to beat their benchmarks consistently. While I don't have any specific formula or a basis to say that you allocate an X per cent of your portfolio to passively managed funds, while the remainder to the active funds, but there are certain considerations to think about.
One is that passive funds make sense for new investors because they greatly simplify choice. Thus, the only matrixes that you need to consider are the expenses and the tracking error and you can simply go for a combination of low expenses and low tracking error. Also because these funds largely invest in the large-cap universe of the market, where stocks are relatively less risky and less volatile relative to smaller stocks, it may be more suitable for a new investor who is not used to the ups and downs of the market.
Moreover, index funds make a lot of sense for conservative investors who only want to allocate a small portion of their portfolio to equity and otherwise, a bulk of their money remains in fixed income. These investors, by their nature, tend to be risk-averse and therefore, the large-cap universe is suitable enough for them to get an equity allocation. Also, the low cost is of great value to these otherwise fixed-income investors.
More broadly, I would say, if you are an investor who believes that the days of active management in the large-cap universe are over, you can simply allocate that much money to an index fund. For example, if you look at flexi-cap funds (erstwhile multi-cap funds), they have about 65-70 per cent of their money invested in large-cap stocks. Thus, you can create your own flexi-cap funds by investing 65-70 per cent of your allocation of a flexi-cap fund in a large-cap index fund and the remaining in a select few mid and small-cap funds. This way, you can create a flexi- cap-like allocation with a bulk of your money still in index funds. This strategy would certainly reduce costs but it will require you to be much more hands-on with your investments.