Rules-based Investing: An Introduction

Experience is the best teacher. This is especially true with the investment world, which has constantly evolved and innovated to bring new investment strategies and products with time. We all have been

pretty familiar with the active style of investing. But now, with the markets deepening, evolving and maturing, we are seeing increasing interest in new investment strategies of passive and rules-based investing. These are interesting concepts of which we feel that investors should be aware.

Introduction to Active & Passive Management: 

Active Management: 

This is a very common strategy where professional investors or fund management teams take investment decisions on every single security (stocks, bonds, etc.) to either buy, hold or sell from the portfolio. These decisions are in line with the portfolio theme and investment objectives. This style of portfolio management is most commonly seen in mutual funds and PMS. Here, the fund managers have the discretion or freedom to buy/sell any security. The security selection, the proportion /share of the security and the timing of entry /exit are all determined by the fund management team and there is active use of research, information, fundamental & technical analysis, risk assessment, etc for making these decisions.

Active management is aimed at generating ‘alpha’ returns, or higher returns than the benchmark of the scheme /portfolio. The fund managers generally engage in buying and selling securities on a fairly regular basis. Active management thus comes at a higher cost to investors due to higher fund management and transaction costs.

Passive Management: 

Passive management is almost the opposite of active management. Here, investors have a choice of either investing directly in an Exchange Traded Fund (ETF) or going with an index fund offered by mutual funds. This is a laid back approach to investing where the role of the fund manager is limited to track a given index like BSE Sensex or Nifty 50. The idea is to replicate and mimic the returns of an index, as opposed to outperforming the index. The chosen index dictates the choice and proportion of the stock/security. 

Here, there is no discretion or liberty to choose and proportion of securities, which generally remain unchanged for longer periods as compared to active investing. This style of investing thus has the benefit of lower costs. 

Active vs. Passive: 

Active or Passive - which is better? There is no easy answer to this question. Both styles of investing have their pros and cons, and both have their relevance and importance in the Indian markets. The markets currently are dominated by active investment style and passive investing is at a nascent stage but growing slowly.

While passive investing is relatively new and the results of long-term investment success are yet to be understood and evidenced fully in India, in developed markets like the US, it is widely accepted and is popular. Active investing on the other hand does hold the promise of higher returns, but at a higher cost, and the challenge of outperforming the benchmark is not easy. In markets like India, active management still makes sense where there are widespread opportunities for superior stock /security selection to generate alpha. 

Let us now ask a simple question? Isn’t there any investment strategy that takes the best of both, active & passive investing? 

Rules-based Investing: Rules-based investing is a strategy that takes the best of both worlds, active and passive investing. Rules-based investing, as the graph depicts, aims to deliver active returns (alpha over the benchmark) in a cost-efficient way by following smart investment/portfolio rules.

The core and success of this strategy lies in building rules - rules which are derived based on multiple, time tested factors. These factors can be market and economic indicators like valuations, long term sovereign bonds yields, interest rates, liquidity, etc at the macro level and factors like market momentum, volatility, security indicators like value and quality and so on at the micro /security level. Using the history of how these factors play out, smart models of investment strategy are formed to identify opportunities between asset classes and securities. 

These rules guide the fund managers on asset allocation (between equity and debt), security selection, entry and exit decisions and the proportion of the security in the portfolio. As can be understood, personal bias is removed and there is a greater discipline in the entire portfolio management process. The building of the rules even requires the expertise of data scientists/statisticians in addition to senior fund managers and with the new age of computing power, it is now easier to identify and build smart rules and benefit from investment opportunities in the real world.

Rules-based investing or factor-based investing or smart beta, with whatever name called, may or may not have variations to the strategy which we just discussed, but the essence remains the same. This may be a new concept in India but, again, has been popular in developed, western countries. Over time, this style of investing is likely to gain popularity in India too. As can be understood, rules-based investing lies in the middle of active and passive investment strategy and aims to deliver the best of both worlds and should be an interesting product to explore for investors here in India in the coming days.


Active, passive or rules-based investing, your choice of the investment decision should be driven by your own investment objective and risk assessment. It is difficult to say which particular style or approach is the best, and perhaps the verdict will never be out soon. As investors, though, we should be educated on the choices we have and appreciate the nuances of the different styles of investing. The measure of success for us should be if we manage to achieve our own, personal investment objectives and life’s goals, irrespective of product selection or any returns we get. This should be at the back of our mind, whatever we do or choose not to do with our money. Happy investing! 

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