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The world of the stock market reminds me of a very old saying which has almost stood true in every aspect of life including the stock market, “slow and steady wins the race”. Like an old wine, the longer an investor holds his investments, the longer the investments have time to mature helping with decent returns.
Passive investing is one of the most popular types of investing. It is a long-term strategy for building wealth by buying securities that mirror stock market indexes, then hold them for a long term.
Table of Contents
Table of Contents
What are Passive Funds ?
A passive fund is a type of fund that religiously tracks a market index to allow a fund to fetch maximum gains. The fund manager does not actively choose what stocks the fund will be composed of, which makes it completely opposite of the active fund, and it makes passive funds easier to invest in than active funds. Also, passive funds are a good way for a beginner investor because you do not need to research and worry about the best performing fund.
How Does a Passive Mutual Fund Work?
Passive funds are mutual funds that replicate the market index and aim to generate returns similar to the overall market performance. In India, you can find primarily track indices like Nifty 50, Sensex, Nifty Next 50 etc. The fund manager simply replicates the index composition instead of actively picking stocks from the share market.
Passive funds provide investors with diversification and market-linked returns in a low cost and transparent structure. They are ideal for those seeking broad market exposure for long term wealth creation rather than beating market returns. Major fund houses like UTI, SBI, and HDFC offer passive funds tracking various indices.Passive fund indexing helps generate market-aligned returns for long-term investors in India.
Types of Passive Mutual Fund
The different types of passive mutual fund are as follows:
Index Funds
These are the most common types of passive funds. In index funds, the allocation of assets is done by replicating a market index like the Nifty 50 or Sensex. They invest in the same stocks with similar weightage as the underlying index.
Exchange Traded Funds (ETFs)
ETFs are passively managed funds that track an index but are listed and traded on stock exchanges like shares, and their prices vary depending upon the NAV. They can be bought and sold anytime during market hours, offering better liquidity to investors
Fund of Funds
These funds invest in units of overseas index funds/ETFs to provide exposure to global indices like the S&P 500 or sectoral indices. But you must note that the fund manager decides how much to invest in other mutual fund schemes.
Gold ETFs
In this type of passive mutual fund, investors can invest in physical gold and mimic domestic or international gold price movements. Enables easy exposure to gold prices.
Smart Beta
In this type of passive fund, you get a mix of benefits that are achieved by both passive and actively managed mutual funds. Therefore, in these funds, you get the underlying index when it performs well. And on the other hand, the funds are managed depending on the stock market performance.
What are the advantages of investing in passive funds?
- Lower Costs – Passively managed investment products like ETFs, or index funds tend to have lower expense ratios as compared to actively managed funds. This is because the investment team has almost negligible role to play in terms of selection of stocks and determination of investment timing considering the need of only tracking the changes in the composition of benchmark indices. Consequently, the fund management charges and transaction costs are minimal, thereby resulting in lower costs for the investors.
- Diversification – Since the benchmark indices are constructed to have an overall market representation, comprising different sectors and segments of the market, investing with a passive investment strategy passes the same benefits of diversification across the market segments through a single investment product.
- Elimination of unsystematic risk – Systematic risk is the risk of market movements due to changes in the macroeconomic indicators like economic growth, current account deficit, etc. Unsystematic risk refers to the risk other than the systematic risk. In other words, it is the risk of selection of wrong investment products or improper timing of investments in the mutual fund scheme. Since the passive investment strategy does not render such flexibility to the fund managers, such risks stand mitigated for the investors.
What are the Risks Associated with Investing in Passive Funds?
Here are some of the main risks associated with passive mutual funds in India:
Market risk
Passive funds invest in the overall market and do not make any attempt to beat the market. So the fund’s performance is directly linked to market ups and downs. During market downturns, passive funds will also see a decrease in their value.
Index tracking error
Passive funds may not be able to exactly replicate the index due to various reasons. One of the reasons is that it leads to index tracking errors, which cause some deviation in the fund’s performance vis-a-vis the index.
Liquidity Risk
There can be liquidity issues if the underlying securities they invest in have low liquidity in secondary markets. This is especially true for passive funds tracking illiquid indices.
Rebalancing risk
When index composition changes, the fund has to rebalance its portfolio, which leads to transaction costs affecting returns.
So to conclude the risk related to passive funds, while passive funds have relatively lower costs due to minimal active management, they are not completely risk-free and investors should be aware of the associated risks.
Passive funds for new investors
Choosing the right investment fund for your portfolio can be a tedious and challenging task for beginners, especially if you do not have an expert by your side to guide you through. You need to first understand your portfolio requirements and then look for the right fund by studying fund style, performance cycles, risks, etc., and continue to review and track the fund consistently. For beginners, passive funds like index funds are a simpler choice. Index funds are simple, easy to choose and track, available at a low-cost, and offer market linked returns.
Passive funds for seasoned investors
Investors who already have a portfolio of active funds can add passive funds to complement their portfolios and potentially enhance risk-adjusted returns. The addition of passive funds to the portfolio may reduce some risks of underperformance that may come through in an active fund in the short- term due to different investing styles.
What is the Fee Structure Of Passive Funds?
One of the major reasons behind the popularity of passive mutual funds is their low cost when compared to actively managing funds.
>Due to the nature of passive funds, it requires less effort. You cannot observe active selling or purchasing of stocks in passive funds. The lack ofof aund manager to track the portfolio makes these passive funds affordable. In short, passive mutual funds have a total expense ratio.
Passive Funds VS Active Funds : How are they Different ?
There are significant differences between active and passive funds, such as management style, cost, tax-efficiency, and performance goal.
- Management style: The primary difference between active vs passive funds is how the funds are invested and managed. For example, an active fund manager has some discretion in security selection, as well as the timing of trades. In contrast, most passive fund managers can only buy and hold the securities that are in a benchmark index, such as Nifty. Index fund managers must also passively hold the securities at roughly the same weighting as the index. Some active funds might also hold only Nifty stocks but their managers can use discretion in which stocks to buy, which to avoid, and how to weigh the holdings.
- Costs: Actively-managed funds generally have higher costs, measured by an expense ratio, than passively managed funds. This is because active management generally requires more research, analysis, and trading compared to passive management by a dedicated experienced analyst or financial advisor.
- Tax-efficiency: Since actively-managed funds tend to have higher turnover (more buying and selling of securities in the fund), they tend to generate more capital gains distributions to shareholders compared to passively-managed funds.
- Performance goal: Actively-managed funds generally attempt to outperform a broad market index; whereas passively-managed funds generally attempt to match the performance of a benchmark index, less management fees. For example, an actively-managed large-cap stock mutual fund would typically attempt to outperform the S&P 500. A passively-managed S&P 500 index fund would attempt to replicate, less fees, the performance of the S&P 500 index.
Investors who want to achieve returns that match a benchmark index, less expenses, may prefer a passively-managed index fund. Deciding whether or not to invest in active funds vs passive funds is a personal choice and can depend on multiple considerations, such as an investor’s unique risk profile and financial goals. Some investors combine active and passive styles within a portfolio, while others may choose neither and invest in a completely different security type. In India, ETFs are also a popular option for investors, offering a convenient way to gain exposure to various asset classes and investment strategies while being traded on stock exchanges like individual securities.
According to market experts, there is no right or wrong choice between investing in active and passive funds. If you prefer minimal risks, go for a passive fund that gives moderate returns. If you want high returns, assess your risks, and invest in active funds. You can also invest partially in both types of funds.
If you are a beginner or a seasoned investor, ShareIndia is a good place to research and compare funds based on returns, risk levels and your financial goals. Click here to contact our ShareIndia experts.
Conclusion
According to stock market experts, there is no right or wrong choice between investing in active and passive funds. If you prefer minimal risks, go for a passive fund that gives moderate returns. And If you are looking for better returns and want high returns with higher risks, so invest in active funds. You can also invest partially in both types of funds.
So if you are a beginner or a seasoned investor, Share India is a good place to research and compare funds based on returns, risk levels and your financial goals.