Active funds can generate positive alpha (greater returns than their benchmark index). Passive funds can moderate regret. One is not necessarily better than the other. Continuing with our previous discussion about luck and fund investing, we look at the behavioural benefits of choosing passive funds.

Uncertain outcome

Equity investment has uncertain outcome. You invest through a systematic investment plan (SIP) in an equity fund to accumulate money to fund child’s college education ten years hence. You do not know till you redeem units if your investment will generate the return required to achieve the goal. Such uncertainty causes anxiety. It is in this context you must mull passive funds’ benefits.

True, passive funds also expose you to uncertain outcome. But active funds magnify this effect. How? With active funds, the uncertainty is compounded because you do not know whether the fund will underperform (negative alpha) or outperform (positive alpha) the benchmark index. The outcome of the alpha has its consequences. Positive alpha can help comfortably achieve your goal, whereas negative alpha could lead to a shortfall in accumulating the money required to meet your goal. That is not all.

Suppose you decide to invest in a Nifty ETF (exchange-traded fund) for a goal-based portfolio. All Nifty ETFs will have the same portfolio — the stocks of the Nifty Index. Also, asset management companies typically charge similar fee for an investment product. Therefore, all Nifty ETFs generate similar returns, eliminating regret arising from fund choice. This is not so with active funds. There are many funds to choose from, say, large-cap with different alpha returns. Therefore, there is a strong likelihood that funds you did not invest in will perform better than the ones you did! This regret exists through the time horizon for a life goal.

Conclusion

We typically buy lottery tickets and insurance policies, indicating we are risk-averse and risk-seeking at the same time. You could adopt a similar norm for investments — moderating regret for goal-based portfolio, yet actively exposing yourself to regret for trading portfolio. You can do this by investing in passive funds for goal-based portfolio and actively trading to generate alpha. Note your trading portfolio will cause less anxiety compared with a goal-based portfolio as trading outcome is known in a quick time.

(The author offers training programme for individuals to manage their personal investments)

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