ET Alpha Wealth Summit 2.0: ‘It’s Active and Passive, Not Active or Passive,’ says Anand Vardarajan, Tata Mutual Fund

The debate between active and passive investing may be missing the bigger picture, according to Anand Vardarajan, CEO & MD, Tata Asset Management. As markets contend with higher interest rates, persistent inflation pressures and changing valuation dynamics, Vardarajan believes investors should not view active and passive strategies as competing choices. Instead, both can serve distinct roles within a well-constructed portfolio.

Speaking at the ET Alpha Wealth Summit 2.0, Vardarajan argued that portfolio construction should be built around the problem each investment strategy solves. Passive investments can provide a low-cost, index-linked foundation, while active strategies can be used to seek alpha. Multi-asset strategies can add diversification, while higher-risk strategies can provide an opportunity for additional returns, albeit with greater downside risk.

Vardarajan's portfolio construction argument comes against the backdrop of a changing global interest-rate environment.


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He identified the US 10-year Treasury yield as a key number for investors to track, pointing to its sharp rise over the preceding month. The yield had risen by around 70 basis points and touched levels of 5.27%-5.28%, while the 30-year Treasury yield had reached around 5.74%.

According to Vardarajan, the significance of rising Treasury yields lies in their role as a proxy for the risk-free rate. As the cost of money rises, other asset classes have to compete with higher risk-free returns. For equities, that can mean investors demanding higher returns, while companies have to generate stronger profits to justify valuations. Higher interest rates, therefore, can act as a form of “gravity” on equity markets, requiring valuations to recalibrate.

He also pointed to stubborn crude prices and the return of inflationary pressures as factors investors need to monitor in the near term. Against this backdrop, Vardarajan sees little value in framing portfolio construction as a choice between active and passive. His argument is that each approach addresses a different requirement.

Passive strategies, he said, can form the bottom layer of a portfolio by providing low-cost, index-hugging exposure. Active funds can then add a layer focused on generating alpha, while multi-asset strategies can introduce diversification through commodities, currencies and other asset classes.

A further layer can be used for higher-risk opportunities, provided investors remain equally focused on the downside associated with those strategies. The result is a portfolio in which active and passive strategies are not substitutes but building blocks with different purposes.

Vardarajan also highlighted the difficulty of consistently identifying the investments that will generate alpha.

He illustrated the challenge through the analogy of a crowded Mumbai local train. At Churchgate during peak hours, everyone wants the coveted window seat, but there is no certainty about who will get it. In his analogy, the window seat represents the alpha generation.

Fund managers constantly attempt to identify those opportunities, but not every manager can consistently secure the equivalent of the “window seat”. The alternative is to board the train itself—the index—and participate in the broader market journey.

For investors, this is one of the fundamental attractions of passive investing. While an index strategy may not capture the full outperformance of every market winner, it ensures participation in the market's overall performance.

Vardarajan's argument is therefore not that passive investing will always outperform active management. Rather, it is that investors can use passive exposure to avoid making the ability to identify alpha the sole determinant of portfolio outcomes.

The relative performance of active and passive strategies can also depend heavily on market concentration.

Vardarajan pointed to the US market, where the Magnificent Seven have come to represent a significant portion of the S&P 500. He noted that the seven stocks alone would represent a substantial index if they were treated separately, highlighting how much influence a handful of companies can have on the broader benchmark.

In such an environment, active managers who held the leading stocks could outperform significantly. Managers who diversified across a broader set of companies, however, could appear relatively average. Passive investors, by contrast, automatically received exposure to those heavyweight constituents through the index.

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India has experienced similar periods of concentration. Vardarajan referred to the 2017 period when a group of heavyweight stocks dominated the Nifty. Because these companies carried significant index weights, passive investors benefited from their performance, while active managers who diversified away from them could underperform.

The implication for investors is that neither active nor passive has a permanent advantage. Market leadership, concentration and the prevailing investment regime can determine which approach performs better at a particular point in time.

Vardarajan also highlighted an approach that combines passive instruments with active portfolio management. One such strategy uses passive instruments at the underlying level while dynamically allocating across sectors. Quantitative tools and algorithms are used to identify sectors displaying momentum, allowing the portfolio to actively adjust its sector exposure even though the underlying instruments are passive.

For investors, this creates a potential middle ground between traditional active stock selection and straightforward index investing.

The approach is designed to be nimble, with the portfolio able to adjust rather than simply follow a buy-and-hold strategy. Vardarajan also noted that, because the strategy operates through a fund structure, investors do not have to manage the underlying portfolio changes themselves.

SIFs

Another emerging area highlighted by Vardarajan was the rise of Specialised Investment Funds, or SIFs. He described SIFs as a significant development because they can combine features of different investment structures. The category can provide access to strategies spanning equity, debt and commodities, while also allowing capabilities such as shorting.

Importantly, Vardarajan pointed to the lower entry threshold compared with AIFs. The discussion cited a Rs 10 lakh ticket size for SIFs compared with the Rs 1 crore threshold associated with AIFs, alongside simpler taxation.

For investors, the attraction is greater flexibility across different market environments. Traditional equity and hybrid mutual funds are primarily designed to benefit when markets rise. SIFs, by contrast, can potentially give investment managers greater flexibility to participate in, protect against and respond to falling markets as well.

Vardarajan described this as akin to giving a vehicle a “reverse gear”—a capability that can become particularly valuable when markets move lower. The category remains relatively new, but Vardarajan pointed to its rapid growth, citing around Rs 38,000 crore in assets and increasing participation from distributors and investors.

The growing popularity of passive investing is another trend that Vardarajan believes investors should watch closely.

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According to him, the broader mutual fund industry is growing at around 19%, active strategies at approximately 17%, while passive strategies are growing at about 27%. The significance of that difference becomes more apparent when viewed through the power of compounding: a category growing at 27% annually can roughly double in three years, even from a smaller base.

This suggests that passive investing could increasingly become a core component of investor portfolios rather than simply an alternative to active funds.

Looking ahead, Vardarajan expects newer investment products to become increasingly relevant to investor portfolios. He pointed to the behaviour of HNIs and family offices as an indicator of where the broader investment market could move. These investors are increasingly seeking sophisticated strategies that can deliver more efficient tax- and risk-adjusted returns. SIFs are one category attracting growing interest, while passive strategies are already expanding at a faster pace than active funds.

He also highlighted the growth of investment opportunities through GIFT City, where greater product availability and lower ticket sizes could make newer strategies more accessible to retail investors, HNIs and family offices.

The broader message for investors is that portfolio construction is likely to become increasingly layered rather than centred around one dominant investment philosophy.

Passive strategies can provide broad market exposure. Active strategies can seek alpha. Multi-asset approaches can diversify risk across asset classes, while SIFs and other newer structures can give managers greater flexibility to navigate different market conditions.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)

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