Over the last few years, passive investing has found its fanclub rising to a certain extent in India. The total inflows into ETFs in 2022 exceeded 80,000 crore, with the AUM for passive funds as a category growing by more than 140% in the calendar year just ended.
When we look at data more deeply, we observe that there have been months when a periodically particular trend is visible.
During periods of increased volatility, some investors tend to move out of an actively managed fund (usually largecap) and into a passive fund (usually an Index Fund).
For example, in November 2022, while largecap funds had a net outflow of Rs 1,038 crore, Index Funds received net inflows of Rs 8,601 crore. A similar trend was seen on a few occasions in 2022:
This phenomenon is called “Switch trade,” which is when investors are increasingly seen switching to index funds from actively managed funds.
This seems to be a re-balancing act when investors move to index funds from their active counterparts.
Since most index funds are under the largecap category, it can be derived that higher inflows to index funds are occurring at the cost of lower inflows and outflows to actively managed large-cap funds.
The idea is to save on the expense ratio of funds when the returns are looking subdued in the near future. This phenomenon seems to be emerging in the current phase too.
Switch trades can be detrimental to an investor’s alpha, or risk-adjusted return, by introducing unnecessary risk and costs.
Switch trades involve an investor closing an existing position to invest in a new position, which often introduces exit loads, fees, taxes, and the potential for a large price discrepancy.
The same investors tend to flock back to actively managed funds when markets are on upswing.
Switch trades can also be detrimental to portfolio returns due to the potential for differences in prices when investors miss the opportunity of making value investments at lower levels. Thus, it hampers the overall Alpha for the portfolio.
In this process, they can miss some of the best days the market witnesses, and the effect can cause a significant impact on their portfolio returns.
To protect their alpha, investors should limit their switch trades after considering all aspects of the trade, including fees, taxes, and potential price differences.
Additionally, investors should ensure that the switch is in line with their overall investment strategy and goals before entering the trade. Like too many cooks spoil the party, too many switch trades kill the alpha for the portfolio.
So, the best thing an investor can do is make passive funds a part of asset allocation and stick to it.
(The author is CIO and Co-Founder, Valtrust)
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)
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