Mutual fund growth post-pandemic has seen a lot of focus on passive investments like index funds, index ETFs, etc. Passive fund Assets under Management (AUM) has grown 53% annually from ₹80,755 crore on March 31, 2018, to ₹674,783 crore on March 31, 2023. The number of passive funds in India has also increased from 90 to 349. Passive funds make up 17.21% of MF AUM. The passive funds market in India had record inflows of ₹1.55 lakh crore and 121 new products introduced in the financial year. As of May 31, 2023, the AUM of passive funds climbed to ₹717,042 crore, a solid start to the FY24 financial year. These statistics should convince you that the rise of passive investing has been extraordinary.

Birth of Passive Investing

A 1951 thesis transformed investment forever. It found that active fund managers couldn't beat the market. Born in 1929, John (Jack) Bogle wrote it. After one of the worst downturn markets since the Great Depression, Bogle created Vanguard in 1975. Bogle developed the first U.S.-indexed fund in 1976 to mirror index performance. Vanguard Group's First Index Investment Trust (now Vanguard 500 Index Fund) started with $11.3 million. Vanguard Group, the second-largest fund manager in the world, manages this $250 billion fund. Passive management has historically been overwhelmingly supported by academia, including works by Nobel Laureates Eugene Fama, the father of the Efficient Market Hypothesis; William Sharpe, one of the creators of the Capital Asset Pricing Model and the creator of the risk ratio that bears his name; and Harry Markowitz, the creator of Modern Portfolio Theory (MPT).

Passive, or index-style investments, buy and hold the stocks or bonds in a market index such as the Sensex, Nifty 50, or broader market index. A vast array of indexed mutual funds and exchange-traded funds track the broad market as well as narrower sectors such as small-company stocks, foreign stocks and bonds, and stocks in specific industries.

This investment approach has gained significant popularity among millions of investors satisfied with replicating market returns rather than attempting to surpass them, owing to the certainty it offers in terms of you know what you're getting: it's unlikely that a passive fund will underperform the market index by a material margin. Another driver of its popularity is the associated huge cost advantage.

On the other hand, active investing exploits the opportunity to outperform the market with increased flexibility and better hedging and risk management potential would

• holds stocks not in the benchmark
• omits stocks that are in the benchmark
• It holds the same companies as the benchmark but in different weights.

So whether you invest passively or actively, the investors need to understand how the index is constructed and the different weighting structures. For instance, the only difference between Nifty 50- index fund and Nifty 50 equal weights index fund is the difference in the weighing structure.

For any portfolio, including the index, two factors determine performance – one relates to security selection or asset allocation decision, and the other pertains to the weights allotted to the chosen securities. Portfolio weight is the proportion, expressed as a percentage, of a particular holding or holding within an investment portfolio. To ascertain the weight of an asset, one may divide the invested amount in a security by the whole investment amount of the portfolio.

To enable better decision-making, let's break down the concepts to their basics and understand the difference between equally weighted portfolios vs. value-weighted or market cap-weighted portfolios.

An equal-weighted portfolio follows a straightforward principle: each asset in the portfolio holds an equal allocation. This means that whether an investor has five or fifty assets, each contributes the same percentage to the overall portfolio. This approach promotes diversification, ensuring that no single asset dominates the portfolio's performance. It is simple to implement and rebalance. Investors don't need to adjust their allocations continually based on market fluctuations. During periods of economic expansion and bullish markets, equal weighting may shine. This is because smaller-cap stocks, which typically make up a larger portion of equal-weighted portfolios, tend to perform well when economic conditions are favourable. Accordingly, investors with a higher risk tolerance may find equal weighting appealing. However, it comes with higher volatility and may experience more significant fluctuations in value.

Contrary to equal weighting, a value-weighted portfolio allocates assets based on their market capitalization. This means larger companies receive a higher percentage of the total portfolio, reflecting their larger market value. The most notable benefit of this strategy is that it is a passive strategy requiring no (little) active management and, therefore, no active management fee. Such portfolios are automatically rebalanced as security prices fluctuate. This approach ensures that the portfolio is mainly invested in highly liquid stocks, thus reducing expected portfolio transaction costs. Investors aiming for a portfolio that closely aligns with broader market trends and reflects the economic significance of major companies may find value weighting appealing.

Investors may find comfort in the stability and reliable dividends often associated with larger, more established companies exhibiting stability and longevity. Value weighting may offer resilience during economic downturns or periods of market uncertainty. The emphasis on established market leaders can provide a cushion against market volatility. While this strategy might provide more stability, it may not capture the same growth potential as equal weighting. Another characteristic of value-weighted portfolios is that they tend to experience lower turnover, reducing transaction costs and minimizing the need for frequent adjustments. Investors prioritizing stability and a more conservative approach may prefer value weighting. This involves allocating a higher percentage of funds to established market leaders, often referred to as blue-chip stocks. Market values are always changing. Thus, portfolio weights based on them are subject to change as well. Rebalancing is often necessary to keep the relative weighting of the assets in equal-weighted portfolios.  It's interesting to note that investors may determine the sector or regional weights of their portfolios. Investment strategy must be taken into consideration while determining portfolio weights.

Smart Beta strategy exploits this difference, where the management is still passively following an index but with weights based on specific characteristics designed to beat the regular market, for instance the weights are determined on the basis of fundamentals, factors or volatility.

By understanding the nuances of equal and value weighting, investors can make informed decisions to craft portfolios that align with their financial goals based on their preferences and strategies - whether long-term growth, income generation, or capital preservation.

• Long-Term Growth: Investors focusing on long-term growth may lean towards equal weighting, as it allows for exposure to potentially high-growth opportunities in smaller-cap stocks. These stocks may take time to mature but could offer substantial returns over the long term.
• Income Generation: Value weighting might be more suitable if the primary goal is income generation. Blue-chip stocks often pay regular dividends, providing a steady income stream. Investors seeking a reliable source of income may favor this strategy.
• Capital Preservation: Value weighting may be more aligned with this objective for investors whose primary concern is preserving capital. The stability of established market leaders can act as a safeguard during turbulent market conditions, reducing the risk of significant capital loss.

Investors should consider whether a portfolio is equal-weighted or market value-weighted because choosing between these methodologies can significantly impact investment outcomes. This is especially relevant when stock price swings are hard to reconcile with rational changes in expectations for future cash flows or interest rates, and when events with minimal to no long-term implications lead to excessive and absurd price movements.

Over specific periods, equal-weighted portfolios benefit from the outperformance of smaller-cap stocks, contributing to their historical appeal in bullish market conditions. Thus, it may capture unique market dynamics, capitalizing on the growth potential of smaller companies that might be overshadowed in traditional market indices. One has to take a closer look at the economic environment. When interest rates fall, equity markets typically do well. However, when rates rise, there is a generally higher dispersion between the best and worst-performing stocks. The higher the noise in the market, or the more inefficient the market is, value-weighted may not be the best bet.

So, my dear readers, like with most other decisions, it all depends on your personal goals, timelines, and risk appetite. The decision is not to choose between one of them but to blend these strategies together in light of the changes in our economic environment.

Best Regards,

Dr. Tarunika Jain Agrawal Ph.D. 

Alpha Research

Disclaimer

The above views are our expectations of the economy, market and investments. The views may or may not play out accordingly. You are requested to do your own due diligence before making any investment.