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The discipline of Passive and judgment of Active- Diversify

The notorious steering wheel!

Rules make things simple. Do the right thing - if you apply this rule, you don't have to judge a situation or person from its fairness perspective. Just keep it simple by doing the right thing and keep moving.

This is at the core of Passive investing. In an active portfolio, the FM's basis of decision is ground up with criteria being different for different stocks at one point in time, at times taking a top down macro approach too. In a passive portfolio, the index is rigid about the top 2 or 3 rules and lets in flexibility about the rest. This makes things simpler and this simplicity gives room for consistency and discipline as it takes away the judgement from the act. With time, the ‘good’ becomes bigger and the exposure towards ‘not-so-good’ reduces in the index, with the index constituents too undergoing a churn as index gets reconstituted periodically. The inclusion of stocks in the said indice are basis a set of rules applied to form the index and also applied at a set frequency to rebalance the index. In case of broad indices, the rules could be solely full market capitalization or free float market capitalization applied on a Universe of stocks. Nifty 50 also filters for impact cost and presence of derivative contracts. The returns in passive investing are a function of this discipline. Barring Nifty 50 and Nifty next 50, indices are usually wider than fund portfolios. In 2020 the return differential between narrower and wider indices was not much while in 2021 it was high. Diversifying investments vide both approaches - active and passive- makes sense.

The rules for sector indices and thematic ones primarily emanate from eligible basic industries under AMFI industry classification followed by free float market cap. As the AMFI industry classification is arranged systematically to capture a particular sector or a theme, rule based index construction works well. Further weights assigning is a function of free float market cap and weights capping. One can take sector exposure vide a sector index or an active sector fund. Not to forget that the active sector fund would take overweight and underweight positions as compared to the index and try to achieve alpha. Diversification vide both routes would be a great thing to do. Also, a thematic index could try to capture a micro area of the sector, catering to a higher risk reward profile while the fund would have a good mix of steady earnings companies and high-risk reward profile companies. Strategy or factor indices calculate respective factor scores for all holdings in the defined universe, choosing the top stocks for the index basis the scores.

The Passive fund or ETF that is tracking the said index would yield similar returns and not outperform the index. Your capacity to take drawdowns in your investments is like your ability of speed while running. If your heart rate crosses let us say 170, leaving you breathless, it is better to slow down. Else you might not finish the run. To keep participating in the markets, it is fine to be earning only market returns and not more. Earning market returns consistently and for a long period of time is much better than exiting the markets just because the quantum of drawdown that hit you in your chase of alpha or positive excess returns, was not in sync with your risk bearing temperament.

Like, if you believe and apply the rule of 'There is a reason for things to happen in the manner and sequence they pan out' , it saves you from the hassle of delving deeper into the cause and effect of anything happening that is not aligned to your expectations. More importantly it keeps you on the move to participate well in life.

Disclaimer: The views expressed in this article are personal in nature and in is no way trying to predict the markets or to time them. The views expressed are for information purpose only and do not construe to be any investment, legal or taxation advice. Any action taken by you on the basis of the information contained herein is your responsibility alone and Tata Asset Management Private Limited will not be liable in any manner for the consequences of such action taken by you. Please consult your Mutual Fund Distributor before investing. The views expressed in this article may not reflect in the scheme portfolios of Tata Mutual Fund.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully

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