Can I hold 25% of index mutual funds in my equity portfolio?

Published: September 17, 2020 at 10:36 am

A reader asks, “can I hold 25% of index mutual funds in my portfolio?”. Superficially it might seem like a wrong thing to do. However, it depends on the index and the rest of the equity portfolio.

A typical retail investor holds a handful of mutual funds from different categories. If such an investor wants to add an index fund, then it would make little sense. Already their net return would be close to the “market return” because of extensive portfolio overlap among the funds.

Adding one more fund – active or passive – will be of little use. If such investors want index funds in their portfolio, they would have to significantly trim down the number of funds. However, the motive behind this “25% exposure” also matters.

If it is a case of “fear of missing out” – including a recent performer just in case, or for “averaging out”, then the impact in the portfolio would be minimal. Passive investing should not be treated as a flavour of the season.

Ideally, passive investing seems like an all-or-nothing strategy (hence the reference to 25% seeming wrong in the opening strategy). That is, either an investor is 100% passive or 100% active. Certainly, for most investors with cluttered portfolios, his reasoning does hold water.

That said, the annoying “it depends” response also is true. Adding a Nifty 50 index fund to a portfolio of only large cap funds or aggressive-hybrid fund is not of much use – unless the motive is to gradually shift from active to passive.

Adding 25% (as an example) of Nifty Next 50 index fund to a large cap portfolio (of MFs or stocks) is acceptable as the fund is generally more volatile and has the potential to outperform the Nifty. Caveat: As the market matures, the outperformance gap will gradually reduce: Do not expect double-digit returns from Nifty Next 50 index funds!

After the recent SEBI ruling, an investor can hold 50% of Nifty 50 index fund and 50% of a multicap fund (with 25% each of large, mid and small caps). The overlap between the two funds would be non-zero but still acceptably small and the portfolio would be fairly stable due to its large cap tilt. However, add one more diversified equity fund to it, the benefit would quickly drop.

One could construct such two -fund or three-fund portfolios in many different ways. For example (1) Nifty 50 index fund + active mid cap fund (or small cap fund or both); (2) Hybrid fund (aggressive, dynamic) + Nifty Next 50 fund. Portfolio construction essentially boils down to assembling products with a distinctly different objective. The number of products necessary, and the “objective” itself are merely opinions.

Yesterday’s (Spe 16 2020) news of UTI MF filing an NFO – UTI Momentum Index fund that would track the Nifty200 Momentum 30 Index, offers a new shade to this topic. If the NFO does launch (it need not), then it would be the first factor-based index fund (we have some ETFs).

While this is likely to be more expensive than say a Nifty fund, it would still be the most cost- and tax-effective way to invest in a momentum portfolio. For those who appreciate the associated risk, “some exposure” to this index fund is acceptable provided the rest of the portfolio is not cluttered.

Some investors ask, “what is the problem if I have one fund too many? I would get some kind of averaging benefit, right?”. If you have two funds it is easy to find out what role each plays in the portfolio risk and reward.  This is impossible if you have five. Those who want “averaging benefit” (this is too hard a concept for me to grasp) will never know if it worked or not.

In summary, while index funds can be part of an active fund portfolio, the investor must be in a position to justify the choice to their rational side (assuming one is present) and after investing should be able to gauge the role play by each constituent. Index investing cannot be considered as a flavour of the season.

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