Active Index Fund

Active Index Fund is designed to track a benchmark index and allow for active buying and selling of securities by managers.
Active Index Fund
4 min
14-December-2024

An active index fund is supposed to mirror its underlying benchmark index and for which the fund managers actively buy and sell securities in order to outperform the returns of the benchmarked index. Smart Beta Funds and Tilt Funds exemplify index funds. In India, active index funds are referred to as mutual funds.

For investors investing in mutual funds, active index funds represent the next step in the investment journey from passively managed funds. While passively managed funds try to replicate an index generating index-linked returns in the process, active index funds go beyond passive management and try to beat the underlying index. Let us understand what active index funds are, examples, advantages and drawbacks, associated costs, and investment approaches.

What is an active index fund?

All actively managed index funds are composed of a specific basket of stocks that may or may not be a part of the index it tracks. The active index fund meaning is clear because the fund manager is actively choosing stocks and altering the portfolio composition to take advantage of market cycles and generate additional returns.

Therefore, an active index fund combines passive fund management and active fund management strategy to beat index returns. There could be a tilt approach or a smart beta approach to active investing.

Understanding active index funds in detail

The active index fund constructs the fund by purchasing the constituents of the underlying index. This builds up the initial investment. After this process, the fund manager adds stocks that are unrelated to the index or reduces the investment in stocks that are a part of the index. The additional constituents that are not a part of the benchmark index aims to generate additional alpha over and above the index returns. The stocks or securities that are part of the benchmark index represents the passive component of the fund management style.

For actively managed index funds, the fund manager will buy additional stocks or securities that are not at all connected with the benchmark. Through this active investing style, the fund manager can generate extra returns. A fund management house may take the NIFTY Midcap 150 index and build an active index fund with an initial investment in the securities from which the NIFTY Midcap 150 is composed of. As time passes and markets offer suitable opportunities, the fund manager can eliminate some stocks of the NIFTY Midcap 150 index and choose stocks that are in no way related to the above index.

Suppose if the fund manager has a view that some small cap stocks can give a good run up in the short term and thereby increase the returns for this active index fund, he will actively cut positions on some stocks of the NIFTY Midcap 150 index and buy those small cap stocks. He can also employ a strategy wherein he alters the weightage of the stocks in the active index fund. Accordingly, active index funds incorporate a tilt strategy or a smart beta strategy for fund management.

1. Tilt strategy

In the tilt strategy, the core stockholding replicates the holdings of the index except a few stocks that are added to tilt the performance of the fund towards additional returns. A tilt strategy for the NIFTY Midcap 150 will involve investing most of the capital in the Midcap companies. But the remaining part may be invested in small cap stocks that are in an upswing. A value tilt strategy employs buying small cap stocks that have generated good returns over the long term.

2. Smart Beta strategy

While a tilt strategy employs picking up additional funds to beat the index returns, a smart beta strategy endeavours to simply track the index and change the weightage of the constituent stocks based on market volatility, stock quality, stock momentum, size, and stock liquidity.

In essence, smart beta strategies alter the weights of the market capitalisation from the index because the index market capitalisation is not efficient in generating the expected returns. While this strategy can be said to be more similar to the passive management style compared to the tilt strategy, it does not ideally track the index but plays with the weightage of the constituent stocks for generating additional alpha.

Based on the underlying index, an active index fund can be constructed on the basis of market capitalisation, diversification, sectors, and themes. If you are a seasoned investor and would like to invest in a specific sector, chances are that you will find an active index fund in that space. You can visit this website to view multiple such funds.

Example of an active index fund

Consider Quant Mid cap fund that is benchmarked against the NIFTY Midcap 150 index. It can be easily seen that the portfolio allocation of Quant Mid Cap fund employs a tilt strategy as well as a smart beta strategy. The NIFTY Midcap 150 index does not contain Reliance Industries Ltd. in its portfolio but Quant Mid Cap fund has allocated around 10.5% of its capital to Reliance Industries Ltd. Additionally, HDFC Bank and Magma Fincorp feature in the portfolio basket of Quant Mid Cap fund but not in the index These are good examples of tilt strategy wherein additional stocks that are not a part of the index have been added to the portfolio of Quant Mid Cap fund to generate additional returns.

This fund also employs a smart beta strategy in which the weights or allocation percentage of a particular stock is altered from the underlying index. Aurobindo Pharma constitutes 1.13% of the NIFTY Midcap 150 index. However, Quant Mid Cap fund has allocated around 8.3% of its capital towards Aurobindo Pharma. Another example of implementation of the smart beta strategy would be NHPC Ltd. which makes up 1.08% of the holdings of the NIFTY Midcap 150 index. However, Quant Mid Cap Fund has increased the allocation of NHPC to 4.41%.

If the returns are compared over a 5-year period, Quant Mid Cap Fund has been able to generate around 36% CAGR returns, whereas for the same time period the index has generated around 29% CAGR returns. Quant Mid Cap Fund has been able to generate this extra 7% alpha because of active index fund management employing the tilt strategy and smart beta strategy.

Advantages of active index fund

The advantages of active index funds are manifold. Active index funds outperform the benchmark index performance and generate additional returns for investors. They are particularly suited to investors who have some experience investing in passively managed funds and are willing to take more risk for getting higher-than-average returns.

Active index funds offer a good degree of flexibility to the fund manager. The fund manager can alter the weights of the stocks present in the index, buy new stocks, and prune existing stocks on the basis of his viewpoint on certain sectoral themes playing out in the future. He can also rely on the momentum generated by a few stocks and prefer investing in the short-term to take advantage of those upward swings. Whenever an opportunity presents itself, the fund manager can choose to exit a stock at a profit. Though there is a core portfolio consisting of stocks from the underlying index that seeks to imitate a passive fund management style, the fund manager of an active index fund is well-placed to take advantage of market opportunities in the short-term, medium-term, as well as long-term.

A very important benefit of an active index fund for an investor is that he can rely on the fund manager’s vast expertise and knowledge in taking selective bets that generate additional returns. Fund managers typically manage a number of funds and combining the fund objectives and their investing styles decide on an appropriate portfolio allocation. Investors usually pay fund management fees as a percentage of their invested capital but derive greater value from the fund manager’s experience and keen market sense.

Limitations of active index funds

Active index funds generally have advantages that outweigh the fund’s expense ratio. However, investors must be mindful of the drawbacks of an active index fund before deciding on the portfolio allocation of their capital.

An active index fund is more expensive than a passively managed index fund benchmarked against the same underlying index. An active investment style comes at a cost and the costs are typically higher fund management fees and higher transaction costs. Frequent churning of the portfolio in order to take advantage of market cycles result in higher transaction costs for active index funds. Active index funds have a team that analyse market trends, economic data, sectoral outlook, segment outlook, and finally recommend possible allocation mix to the fund manager. The fund house needs to subscribe to websites that provide authentic data and research reports. All the research and analysis effort, subscription costs, and fund manager’s expertise adds up to higher fund management costs. While considering returns generated by an active index fund, it is also necessary to account for the higher costs incurred by an investor.

Other limitations are related to the fund manager. Since fund houses charge higher fund management fees, fund managers are under intense performance pressure. Some fund managers have the intuition to spot patterns and hotspots not easily observable to everyone, and therefore they make decisions that consistently result in market-beating returns. However, a majority of the fund managers are unable to time the market properly or choose the correct stocks, and thereby cannot beat the returns of the index.

In an active index fund, an investor has to rely solely on the fund manager’s expertise and ability for generating additional returns. Along with his expertise and experience, the fund manager also brings his bias in the decision-making process. For example, there might be a particular market condition that demands investing style A but the fund manager has an investing style B. He cannot completely embrace style A just because of his bias towards style B. In the long run, it has been seen that a passively managed index fund beats an actively managed index fund. As per a report, around 62% of the actively managed large cap funds and around 75% of the actively managed mid or small cap funds failed to beat the benchmark for a 10-year period.

Are active index funds a good investment?

For an investor, a good or a bad investment depends on his risk profile and financial goals. Active index funds consistently take more risks in the manner of timing the market, leveraging market dynamics, and capitalising on short-term chances in order to achieve a higher growth rate than that of the benchmark index.

Consider an investor Mr. D who joined the workforce a few years ago and has built a substantial corpus for investment. He seeks more returns than the market in 2 - 3 years and plans to reinvest the appreciated capital in other active index funds subsequently. He does not want to wait for more than 5 years in order to realise his gains and can afford to take more risk for the additional alpha. Therefore, Mr. D should consider investing in active index funds because they align with his investment horizon, risk profile, and wealth goals.

Are active index funds more expensive?

Active index funds have higher fund management fees and transaction costs. Typically, analysis of market cycles, economic indicators, sector forecasts, and themes along with annual subscription cost towards databases for fund houses result in higher fund management charges. Additionally, stocks in the portfolio basket of active index funds are frequently churned and rebalanced to take advantage of market opportunities.This results in higher transaction costs for the fund house. These factors cause an active index fund to be costlier than a passively managed fund.

Does an active index fund involve market timing?

An active index fund has to capitalise on market opportunities. While passive funds cannot hold cash and must rigidly adhere to the weightage of stocks in the underlying indices, active funds can always hold cash for grabbing market opportunities that arise due to market inefficiencies. Suppose, a fund manager of an active index fund is keen to invest in a particular stock belonging to the BFSI sector but he finds that the stock is overvalued. The stock is fundamentally strong and he waits for the correct buying opportunity. The central bank sends a letter to the company management for clarification on a particular high-value outward remittance transaction. The market reacts to this news negatively and the stock price of this company corrects. This situation is an opportunity for the fund manager to buy those stocks in bulk.

Summary

An active index fund represents an active fund management style on top of a passive strategy. Though it tracks an index, fund managers regularly take advantage of market volatilities to generate additional alpha for investors. You can consider active index funds in your portfolio if you are seeking an exposure to equity markets without investing in individual stocks.

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Frequently asked questions

What is passive vs active index fund?
A passive index fund simply tracks the benchmark index and allocates stock holdings in the same proportion as the index. An active index fund may eliminate stocks from the index or change the allocation percentage to a particular stock.

How to tell if a fund is active or passive?
If you see the same stocks and similar allocation percentage in the portfolio of a fund as in the underlying index, you can be sure of the fact that it is a passive fund. For an active fund, the stockholdings and weightage will differ from the index it tracks

Are Active Index Funds a Good Investment?
If you are willing to take more risk and require more growth than the index offers, you can consider investing in active index funds.

Is it better to invest in active or passive funds?
Investing in active or passive funds is a matter of an individual’s risk profile, financial goals, and horizon. An investor who can stay invested for a long time and requires index-linked returns can invest in passive funds. However, for an investor requiring capital appreciation in the short-term, active funds will be a better choice.

Are Active Index Funds More Expensive?
Active funds are more expensive because of higher fund management and transaction costs. If investing in active funds seems too costly, you can prioritise passive funds in your portfolio mix.

Does an Active Index Fund Involve Market Timing?
Active funds need to regularly time the market in order to outperform the index it tracks.

What are advantages to index fund investing?
Index fund investing is less risky than investing in individual stocks. Because of portfolio diversification, the risk is spread in index funds.

What is the return rate of index funds?
Different categories of index funds have varying returns. Actively managed large cap index funds will have lower returns than actively managed mid cap or small cap index funds. Large cap index funds tracking NIFTY 50 should generate more than 12% over a 10-year period.

Should I choose active or index funds?
You can analyse your risk taking ability and wealth goals before making a decision. A thumb rule would be to avoid actively managed funds if you have a low risk appetite.

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