All you need to know about passive investment options

With government’s support and SEBI’s efforts to streamline investments through mutual funds, we may see more and more investors tilting towards passive investment options.

The debate regarding active and passive funds is going to be bigger and bigger in the coming days in India. This is partly due to government support, which recently divested its holdings in PSUs through CPSE ETF and mopped up Rs. 11,500 crore. Other reason being underperformance of large-cap funds against their benchmark indices. This is further going to accentuate once new SEBI regulations kicks-in, which tries to define the market cap in a much clearer way and has asked fund houses to stick to the fund mandate while allocating investments.

A passive investment strategy is an investing strategy that tracks a market-weighted index or portfolio. They mostly imitate the holdings of a specified index. This is quite common in the equity market, where index funds track a stock market index such as BSE Sensex or Nifty, however, bonds, commodity market and hedge funds are also not aloof of such concepts and there are funds that track an investment in the bond and commodity market.

They are popular because they give higher returns compared to a similar fund with similar investments. They could achieve this because of lower turnover and lower management fees. On an average, the expense ratio of ETFs is around 0.6  per cent  compared to around 2  per cent  for actively traded equity diversified fund. In terms of volatility too, historically ETFs have witnessed lower volatility compared to active funds. Hence, ETFs give better risk-adjusted returns compared to similar active funds.

Two modes of passive investments are popular, one is ETF and other is an investment in Index funds.

ETFs are traded like stocks at the stock exchange. We can buy or sell at any point in time throughout the day and the prices keep on changing just like a share price. Exchange traded fund (ETF) has higher liquidity and lower transaction fees compared to any mutual funds. However, depending  upon  the commission and brokerage it may increase. ETF holders are entitled to get dividends. Exchange traded fund are traded on public stock exchanges

Index funds are like any other mutual funds the only difference is that these funds track the particular index like Nifty, Sensex, etc. An index fund invests in all stock of a chosen index. Index funds  too  have lower expense ratios.

Difference between ETF and Index funds

ETFs invest in commodities, stock, bonds, means a variety of securities, while index funds invest in a particular index.

Exchange traded fund has lower expense ratio compared to the index fund. The average ETF carries the expense ratio of 0.44%, while average index fund carries the expense ratio of 0.74  per cent .

Exchange traded fund has higher transaction cost compare to index fund as there is no transaction cost and commission in the index fund because ETFs are bought and sold like stocks, you will pay a commission to a broker each time you buy and sell.

Index funds have higher liquidity than ETF. This is because you can always redeem your investment in the index fund to fund houses, however, in case of ETF you can buy or sell only if there is someone willing to buy your units at any time during market hours.

In the exchange-traded fund, the minimum investment is lower than the index fund. Passive investment in India is still at nascent stage, however, as the market matures we may see more and more investors willing to take the passive route of investing.