Passive Investing: All you need to know and why it is right for you

There is lot of conversation happening on passive funds these days and at a same time many asset management companies including stock broking firms are planning to launch their new passive fund products. While the name clearly suggests something which is not active but follow a passive investment approach, lets dive deep to understand more on it.

What are passive funds?

Passive funds invest in a basket of securities which track a market index. Weights of securities in the fund mirror the weights of the constituents in the index. Unlike actively managed mutual funds, a passive fund does not aim to beat the market. In other words, passive funds give market returns subject to tracking error (we will understand tracking error later in this article).

Why should you invest in passive funds

• Low cost: Expense ratios (TER) of passive funds are much lower than actively managed funds. The fund manager of an actively managed fund will have to generate significant alphas on a consistent basis to match the performance of a passive fund tracking the same benchmark index. Suppose the TER of an active fund is 2%, while that of a passive fund tracking the same benchmark index is 0.25%. This difference in costs implies that the active fund will have to consistently beat the benchmark by at least 1.75% to match the performance of the passive fund. Over long investment horizons, lower costs may help you in getting considerably higher returns due to the compounding effect.


• No unsystematic risk: In order to beat the index (create alpha), the fund manager of an active fund will have to be overweight or underweight on certain stocks in the index. This will result in unsystematic i.e. stock or sector specific risks. While unsystematic risk can lead to outperformance, it can also result in underperformance. Unsystematic risk is an additional risk in investment over and above market risks. There is no unsystematic risk in passive funds. Passive funds are only subject to market risks.


• No human behavioural biases: Fund managers are humans like the rest of us and they may have behavioural biases which may reflect of fund performance. Moreover, the fund manager of an active fund can change for a variety of reasons, other than performance. This can affect the returns of the fund. There is very little human bias in passive investing.


• Simpler investments: In actively managed funds you should check the long-term performance track record of the fund manager across different market conditions, how long has he / she been managing the fund and understand the investment strategy before investing. Passive funds, on the other hand, are much simpler investments. You simply have to decide which asset class and asset sub-category you want to invest in and then select a fund which has low cost and tracking error.

Now let's understand what is a tracking error?

Tracking error is the deviation of the fund's returns from the benchmark index return. There are a number of factors that can give rise to tracking errors. The most important one is the cost of the passive fund. Higher the cost, higher will be the tracking error. The percentage of fund assets held in cash or cash equivalents can also give rise to tracking errors. Finally, delay in executing buying or selling of securities can also give rise to tracking errors.

What are the types of passive funds

There are two types of passive funds - Exchange Traded Funds (ETFs) and Index Funds. In terms of investment objectives, ETFs and index funds are almost the same - both track a benchmark index. However, there are important differences between the two which investors must understand:-

• You need to have demat and trading accounts to invest in ETFs. Index funds are mutual fund schemes. You do need demat account to invest in index funds.


• After the New Fund Offer (NFO) period, you can buy / sell ETFs only on stock exchanges, unless you are buying / selling in lot sizes specified by the Asset Management Company (AMC). You can invest in Index funds or redeem them with the AMC either directly or through your financial advisor.


• ETF transactions take place at market prices; market prices may be higher or lower than the Net Asset Value (NAV) depending on market conditions. Index Fund transactions take place based on the end of day NAVs, just like any other mutual fund scheme.
• Dividends paid by stocks in an ETF are credited to your bank account. Dividends received by index funds can be paid out to you or re-invested in the fund depending on the option (growth or IDCW).


• TERs of ETFs are lower than those of index funds.

Passive funds of different asset classes

Many investors think of ETFs and index funds as passive investments in Nifty or Sensex. There are passive funds which invest in different asset classes:-

• Domestic Equity: These funds invest in equity indices e.g. Nifty 50, Sensex, Nifty 100, Bank Nifty etc.


• Debt: These funds invest in liquid, G-Sec, PSU and SDL bonds etc.


• Gold: These funds invest in Gold and their returns reflect the returns of domestic Gold price.


• International Equity: These funds invest in international equity indices e.g. NASDAQ, MSCI, Hang Seng etc.

Conclusion

While passive funds can provide you exposure to different asset classes at a low cost, one can also use the passive investment approach for taking exposure in different sectors e.g. Banking, Healthcare, PSU bonds etc.

In this blog post, we discussed the key differences between ETFs and Index Funds, so that you can make informed investment decisions when deciding between the two. While cost is a very important factor, liquidity of your investment and your experience should also be important considerations. Passive funds are very popular in developed markets and are gaining in popularity in India as well. You should consult with your financial advisor about passive funds and which ones may be suitable for your investment portfolio.

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