Let us see what are the sources of volatility:
Market price: ultimately any fund is about the stocks in the portfolio, the everyday price discovery in the market and the resultant movement in stock prices and NAV of the fund. Hence, the NAV is as volatile as the market price movement of the underlying stocks. As an example, a passively managed mid-cap or small-cap fund would be as volatile as that of an actively managed mid-cap or small-cap fund, and more volatile than an actively managed large cap fund.
Relative weight in the index: it is the responsibility of the fund manager to not only have the same stocks as in the designated index, but also in the same proportion. Due to price movement in the market, the relative weights in the index would change, and the fund manager is expected to tweak the portfolio composition accordingly.
Change in the index itself: index composition is not static. There are periodic changes brought about by the index manufacturer. As an example, Nifty and Sensex is rebalanced semi-annually. For large cap indices, it may not change drastically, but for a few stocks making entry and exit. For small cap stock indices, the composition may change drastically i.e. a large number of stocks may make their way in and out. Accordingly, the fund manager of a passive fund has to change the composition of the fund, as per the index composition changes.
In actively-managed funds, though it may not be always possible, it is one of the objectives of the fund manager to deliver risk-adjusted returns, measured by Sharpe ratio and other parameters. Hence it helps the fund manager of an active fund to have low volatility stock. In a passively managed fund, the only parameter is tracking error or tracking difference, and low volatility does not help the fund manager to showcase better performance.
The other perspective we mentioned is the invisible fund manager in passively managed funds. It may seem that there is no fund manager, apart from the designated fund manager to track and replicate the benchmark index. From a broader perspective, the portfolio composition and relative weightage of stocks in a passive fund is as per the designated index. The index itself is a reflection of the value assigned by the market to that stock, in terms of floating-stock market capitalization. There is a price or value discovery done by the market, and on a relative basis, the weightages of the stocks would change places. Hence, in a way, the market is acting as the fund manager, by tweaking the market cap of the stocks.
In other words, all the market participants collectively are deciding the stock allocation of the passively managed fund, which is replicated by the designated fund manager at the AMC. The volatility of the passive fund is as much as what the underlying market is doing to the stocks.
In your portfolio allocation, you choose between actively and passively managed funds as per your suitability and expectations on performance. There are certain passive funds which are not just a replica of an index but brings more to the table. In passive funds like low volatility, smart beta, etc there is a rule-based proposition. You may prefer to go with the wisdom of an AMC with proven track record or with that of the broad market, or both, with allocation to both active and passive ones. Which one of all these would perform better, time will tell. But be clear about the reasons for doing the allocation, and the reason is not that passively managed denotes relatively lower volatility.
(Joydeep Sen is a corporate trainer and author.)