Importance of Passive Funds

Does the term ‘passive investment’ have a ring of boredom to it? Does it sound like that this form of investment does not offer the kind of excitement you would wish for while dealing with money? Maybe it does to a large extent because the word ‘passive’ conveys a lack of interest an.d perhaps even a hint of laziness, neither of which are ideal in an investment strategy. But exchange traded funds (ETFs) and index funds, which may be the most active and dynamic sector of the financial world, are driven by a passive style of investing. So, what exactly is passive investment? At its most basic, it’s an investment that does away with human intuition when choosing what to acquire and when to possess it. 

Investors pool their funds into an ‘active’ mutual fund where the management chooses investments based on their study, instinct and expertise. In a passive fund the components of the fund are decided by an index that is defined by a set of rules. ETFs tend to be passive, but not always. Similar to how stocks are frequently associated with active management, mutual funds can also be passive. Then, what exactly does it mean to have a passive investment? Simply put, passive investing entails owning the market rather than making an effort to outperform it. 

Owning the Market with Passive Funds
In simple terms, controlling the market entails controlling a small fraction of everything relative to its size. An excellent example is a tracker fund that tracks the MSCI World Index. The fund does not attempt to predict which stock will do well. Instead, it makes stock investments across the board, taking bigger interests in bigger companies and smaller ones in the smaller ones. Why would you want to match the market when you might outperform it? Traditional passive investors think that consistently outperforming the market is either impossible or, at best, extremely unlikely. 

All active managers, however, believe that by selecting the best companies and avoiding the worst, they may outperform the market. More passive investing is beginning to be seen in the Indian investment market mainly because of the ‘buy and hold’ method. Since they need fewer management fees or more frequent portfolio modifications, passive investments usually have cheaper costs than active ones. For instance, if they desire to diversify their portfolio, long-term investors can try to increase their wealth through passive investments. To optimise returns, passive funds follow an index of stocks continuously. The portfolio of a passive fund mirrors that of an index fund, such as the Nifty, Sensex, etc. The index for the fund uses the same securities and investment percentages as the original.


 

Types of Passive Funds
Index Funds — The underlying benchmark index is mimicked by an index fund. Theme, market capitalisation, sector or a broad market index can all be the focus. The fund management group’s responsibility is to emulate and maintain the composition of the underlying benchmark as the returns on these funds are practically identical to the benchmark. There will, however, be a minor variation in performance. A tracking error is the cause of the variation. Therefore, an optimum choice is a fund with the smallest tracking error. Furthermore, the same percentage of the underlying index is invested in all the upcoming inflows. 

Exchange Traded Funds (ETFs) — Exchange traded funds (ETFs) are a class of passive funds that mimic an index’s performance. A portfolio called an ETF closely mimics an index. The goal of ETFs is not to outperform their underlying indices. ETFs can also be bought and sold on the stock exchange since they are traded there. The ETF prices change throughout the day as a result. The value of the portfolio is based on the underlying stocks’ net asset values. 

Investment Methodology — Buy and hold is a passive mutual fund investment strategy. The fund management doesn’t spend a lot of time adjusting the portfolio because it closely resembles the benchmark index’s composition. In contrast to active mutual funds, passive mutual funds are, therefore, less expensive investment possibilities. Additionally, passive funds use a variety of investment strategies such as tracking a broad market index or a sector index. 

Returns — The goal of passive mutual funds is to closely match the benchmark index, such as the Nifty or Sensex. In other words, a passive mutual fund’ portfolio composition and stock representation will be more or less comparable to that of the underlying benchmark. Returns from passive funds are comparable to market returns because the compositions are the same. But unlike active funds, passive funds do not seek to outperform the index. The purpose of the passive fund is to generate benchmark returns as closely as feasible. However, compared to active funds, the risk is smaller. Additionally, because passive fund investments are appropriate for long-term goals, the benefits are compounded over time. 

Risk — Passive mutual funds are risky because they are market-linked securities. The risk levels are far lower than those of actively managed funds, nevertheless. Furthermore, as passive funds imitate the benchmark index, their portfolio is well-diversified, and if your investment objective is long-term, you can achieve benchmark returns. Portfolio — Passive funds don’t need to check their portfolios constantly because their structure mimics the underlying benchmark. As a result, when the market fluctuates, panic selling and purchasing do not take place. These funds don’t have any stock or industry bias and are more diversified than active funds. 

Fees — Since passive funds don’t actively buy and sell securities, they are low-cost investment strategies. As they match the benchmark index, portfolio adjustments also don’t happen frequently. As a result, the portfolio need not be regularly monitored by the fund manager. Also, when compared to running an active mutual fund, all related expenses are significantly lower. Therefore, passive funds are well-liked, low-cost investments.





Passive versus Active Investing Active Funds’ Pros

•  Alpha Generating Funds: Actively managed funds are preferable if the investor needs a little bit more than what the benchmarks are providing. Actively managed funds’ primary goal is to produce alpha and outperform the returns of the Sensex and Nifty. Here, the fund manager does market research using his or her time, skills and experience.

Active Funds’ Cons

• Expense: The cost of a fund manager’s knowledge is high, as is the case with all good things in life. Investors will be required to pay fees (expense ratios) in exchange for the fund manager’s knowledge and judgement. n Risk: Since actively managed funds aim to produce larger returns, their associated risk is also higher than that of passive funds. This is due to the possibility of inaccuracy in decision-making processes created by humans. 

Passive Funds’ Pros

•  Cheaper: This is one big benefit of passively managed funds. They have far lower expense ratios than active funds. The expense ratio for ETFs is restricted by SEBI laws and cannot go over 1 per cent. As of 2022, the HDFC Sensex Fund, a prime example of this fund category, has a very low expense ratio of just 0.05 per cent. 

Passive Funds’ Cons

• Unable to Outperform Benchmarks: These funds have modest returns. Returns could be higher, lower, or equal to the benchmark’s returns. Although they might be less expensive, they do come with fees that could somewhat reduce returns. 

Target Investors for Passive Funds

Passive funds offer a low-cost investment option for those looking to invest in equities and earn respectable returns by tracking the relevant benchmark index and | or underlying fund but do not want to experience high volatility, thus making them the perfect choice for new investors who are just beginning their investment journey. It is also a straightforward and practical choice for investors who struggle to select the ideal active fund from the abundance of options. However, investors may find it challenging to assemble a portfolio of passive funds given the flood of new passive funds being introduced across various market capitalisations, investment styles and attracting-looking topics.

In order to start investing in passive funds, choose ones that track Large-Cap indices like the Nifty 50, S and P BSE Sensex, Nifty Next 50, and so forth. To increase exposure across market capitalisation, you might also invest in funds that track larger indices like the Nifty 500. If you want to take advantage of geographic diversification, you can think about investing up to 15-20 per cent of your portfolio in overseas passive funds that track indices like the Nasdaq 100, S and P 500, etc. But go for it only after you have assembled a well-diversified portfolio of equity funds. However, as India is a developing market, companies in the Mid-Cap and Small-Cap categories have a greater potential for long-term outperformance. 

As the economy continues to improve, the market may experience a long-lasting, broad-based rise, which could lead to higher returns for mid-cap and small-cap funds. Therefore, actively managed small-cap and mid-cap funds can still provide fund managers with the chance to produce high alpha. In order to build a diversified portfolio of large-cap, mid-cap and small cap stocks, consider your financial objectives, investment time horizon and risk tolerance. Choose passive investments with a low expenditure ratio and low tracking error to achieve returns that are somewhat greater than the index.
 

Future of Passive Funds

Passive fund AUM growth will be fuelled by the formalisation of employment, or more people joining companies that are subject to PF rules. Passive funds may also experience significant growth as the Indian markets develop and mutual fund companies introduce cutting-edge products based on passive techniques. Indian investors may have more options for portfolio diversification with passive strategies. However, for at least 10 more years, active investing may continue to be the industry’s main driver of growth. This is due to the fact that a majority of investors have the mindset or expectation of not only clocking returns in line with the relevant benchmark index but also outperforming, or generating alpha, which may enable beating inflation better and achieving the desired financial goals quicker.

ETFs or Index Funds - Where To Invest?

Index Funds and ETFs have many similarities. Therefore, your investment goals will determine which one you choose. For instance, you would favour a disciplined approach to investing if you are a long-term investor with long-term goals. The simplest way to do this is through an index fund using the SIP method. However, if you enjoy trading during times of market turbulence, ETFs might be a better option. 
 

Many tactical investors with above-average stock market knowledge frequently trade in ETFs for relatively brief periods, particularly if there has been a news-driven market decline. These 3-odd per cent corrections are typically just transitory, but that doesn't stop individuals from taking advantage. 
 

In fact, the NIFTY 50 has completed a session with a loss of more than 3 per cent 93 times in the past 15 years, and one can actually picture traders and investors scrambling to purchase and sell as necessary. In the end, deciding between an Index Fund and an ETF comes down to picking the right tool for the task. While index funds simplify many of the trading decisions that an investor must make, ETFs provide lower expense ratios and greater flexibility. 
 

As a result, your primary holdings should be index funds. This means that index funds should be the focus of your long-term wealth-building strategy, while ETFs can be used more strategically during news-related ups and downs. 

Conclusion

In the past, outperformance has been used to frame the discussion of whether investors should utilise active or passive methods in their portfolios. But, when an investor uses a hybrid strategy, both can actually coexist. You might need a mix of investments to offer a possible return that can keep up with the effects of growing costs if you want to stay ahead of inflation. The actively managed funds have the chance to select solid companies that are offered at competitive valuations during a market fall. As a result, in a positive recovery, these funds can dramatically exceed the market. That said, buying passively managed ETFs and index funds can reduce the risk of actively managed schemes underperforming. 
 

To generate somewhat greater returns than the index over the long term, choose passive funds with low expense ratios and low tracking errors. In order to protect against inflation, investing in mutual funds that combine active and passive funds is a good idea. The financial goal, investment horizon and risk-taking capacity of investors should all be taken into consideration when deciding whether to invest in an actively managed fund, a passive fund or a combination of the two. To weather market volatility, it is ideal to have a time horizon of at least 5-7 years when investing in equity funds. Finally, refrain from funding too many programmes because it may be challenging to keep track of their success and weed out the underperformers.