Should I now shift active mutual funds to index funds? A step by step guide

It should now be reasonably apparent to the regular freefincal reader that Index funds are becoming harder and harder to beat and that one have easily constructed a minimalist index fund portfolio suitable for all risk appetites and ages. So the question now in many active mutual fund investor is, should I now shift current active funds to index funds? How to do this? Can I still use active funds? If so how? What kind of active funds should I now choose? If I select Index funds, how can I manage risk and downside in my portfolio? Starting with this post, we shall discuss these questions in detail.

If you are new and are looking for evidence for the performance of index funds, then I have written several posts on this. Here are few.

  1. Large Cap vs Mid Cap vs Small Cap Funds: Which is better for long term investing?
  2. Can I start Index investing with 50% Nifty 50 and 50% Nifty Next 50?
  3. List of funds that have outperformed Nifty 200 & Nifty Midcap 150 Total Return Indices
  4. Should I now switch from large cap funds to index funds?

 

1 Are you capable of being an index investor?

First, let me ask this question to new investors who want to use index funds. Index investing implies that you:

  • do not look at star ratings
  • do not seek to beat the market (duh!)
  • do not worry if after six months or 6 years many active funds have beat your index fund

You choose passive investing because it is a low maintenance portfolio that will get the job done for your goals at low cost. People who do not have the maturity to understand that the end game is enough money and not enough returns should not choose index funds or any fund for that matter!

In what follows, I am going to assume that you are capable of being an index investor.

Should I now shift active mutual funds to index funds? A step by step guide

2 Get the first steps right!

Use this active vs passive investing debate and data as an opportunity to look at your investments and check if they have a clear goal and purpose. If your asset allocation for each target is suitable and if you have a plan to change asset allocation with time. Do you rebalance your portfolio at least once a year? For automated help, you can download the Freefincal Robo Advisory Software Template, punch in your numbers and see the magic!

The above is crucial, Do not think about index funds without getting the above in place.

3 Reduce the number of funds that you hold

Again, use this debate to clean up your portfolio. Identify the fund funds that should be removed as explained here: Holding too many mutual funds? Easily trim your portfolio with these simple steps

For this, you must, as described above, decide on the build of your equity portfolio. Then identify the number of funds you need and determine the funds you want to throw away.

4 You have a small portfolio and just started investing

If this is you, then redeem from the funds you want to throw away and switch them to index funds. If you have any aggressive hybrid or balanced advantage funds or multi-asset funds in your portfolio, you can retain them (see below for an explanation). Gradually increase exposure to index funds.

Your equity portfolio can have say (in order of decreasing risk):

  • 50% aggressive hybrid + 50% Nifty Next 50
  • 50% balanced advantage + 50% Nifty Next 50
  • 50% multi-asset (equity oriented*) + 50% Nifty Next 50

* ICICI Dynamic or now ICICI Multi-asset fund is an example

This kind of active + index combinations will balance risk and return well. There are so many other combinations possible,  think, read, research and come up with your own.  Small portfolio here can mean just a lakh or two or less.

5 You have a large portfolio

Large here can mean above 15 times what you can invest each month. Of course, this is an arbitrary definition; you can define as per your comfort level. I would suggest that you trim your portfolio as above and if you already hold balanced aka aggressive hybrid or balanced advantage funds or multi-asset funds, then retain them as the core holding of your portfolio. This is what I do, and I have explained why here: Using Balanced Mutual Funds As The Core Equity Portfolio Holding

Even if you are ready to choose index funds, I think they may not be necessary for you, and there is no need to switch the “laid off funds” to index funds. If you feel strongly about index funds, then you can have a small exposure of 25-30% of your equity portfolio. This will be minimally invasive for your peace of mind, tax and exit loads.

6 Why aggressive hybrid, balanced advantage and multi-asset funds?

As I have explained here, advantages and disadvantages of being a passive investor, index funds do not have any downside protection. That is, if the benchmark falls by 10%, the index fund will also do the same (a bit more if you count expenses). If you want a smoother journey, that is if you want your fund to fall less, you need active funds.

However, do not just choose any active fund. Choose active funds that guarantee downside protection. Choose active funds that invest in 2/3 asset classes and rebalance regularly among them. This means no actively managed large cap, mid cap, small cap, multi-cap, large and midcap, value-oriented, contra, thematic or sector based mutual funds.

In my opinion, the higher expense paid to hybrid funds are justified for the simple reason that there is no hybrid index fund in India. Their benchmarks are not the pure equity indices, and they have no obligation to beat them (although some do). The hybrid investor need not wort about the active vs passive debate and chill out.

7 How should I now choose active funds?

Choose suitable hybrid funds (stick to the ones mentioned above, but understand the investment strategy) and build your portfolio around them. You can either avoid index funds or have a small exposure to them as per your desire.

8 Why no mid cap and small cap funds?

Why do you want to clutter up your portfolio again? As pointed out yesterday, Nifty Next 50 is a fantastic midcap index fund, and you do not need a small cap fund. If you want to choose a diversified aggressive hybrid that invests across the market cap. So it will hold some mid and small caps. And that is more than good enough.

Conclusion

Relax and stop worrying about the active vs passive debate. First, identify your goals, have an asset allocation plan for each, decide on the build of your equity portfolio, trim it down and build around suitable hybrid funds. Add an index fund as an equal partner if you are young and as an apprentice, if you a middle-aged. There is always a simple and easy solution available, provide you have your priorities right:

enough money for future needs, regardless of returns

So, this leaves us with, If I choose Index funds, how can I manage risk and downside in my portfolio? Let us discuss this in another post. I hope this post offers some clarity on the future course of action. If not, let me know the problems that you face, and I will see what I can do. Head over to the freefincal youtube channel and explore the 164 videos available there. If you go to the community tab, you and let me know what kind of videos you would like to watch.

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5 thoughts on “Should I now shift active mutual funds to index funds? A step by step guide

  1. I kind of feel these index posts as a consolidation Professor, not that you will not post anything new that can help me, but I do feel like I have learned enough and found something which erases the confusion and doubt and gives me a sense of absolution. Thank you very much.

    And what about the hundreds of posts you have written all these years, some of them might have lost their relevance and are not that useful in present, or you are simply laying out everything and we get to choose what we like?

  2. Pattu,I dont have any hybrid funds in my portfolio and only pure equity funds(QLTE,Parag,Sundaram Mid). Should i completly switch over to new Hybrid fund and add equal portion of Index funds(NN50).

  3. Sir,
    This point “the end game is enough money and not enough returns” above is an interesting one. I would like to think enough returns is needed to leave us with enough money at the end.
    Why is multicap category not in your picture at all?
    I understand it is very difficult for a largecap fund to choose among 50 stocks and beat Nifty50 index especially with the latest SEBI reclassification rules. But it is definitely possible for a proven fund manager to choose among 500 stocks across caps to beat a Nifty50 return.
    A comparison of few Multicap funds that are more than 20 years old against Nifty50 or NN50 index will provide clarity.

  4. Dear Pattu Sirji,
    My simple question, Where we have come to zeroing for NN50, I can see there is 0.85% for Growth and 0.44% for Direct Growth for this ICICI NN50 , and I guess many active largecap /hybrid MFs offering services below 1% with quite well track record, good risk averse return.
    Should we think this angle too before just switching ?
    Thanks

    Jig

  5. I just saw your you tube video and read many articles after that from your blog. I am 33 years old and have 10lakh portfolio of which 70% is of mirea asset emerging bluechip fund. Now after watching your video and reading blog posts, I think I am doing wrong. Its not too late after I have almost 3 decades before I retire,till then I have regular monthly income. So should i stop my SIP in just one mutual fund? What kind of portfolio now i should build? Starting afresh and invest as explained and leave the money already invested as it is? As this is my first question i expect that you will help my dilemma.

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