Various studies have suggested that equity delivers higher inflation-adjusted returns than any other asset class over a long horizon. The key here is the horizon of investment—the longer one remains invested in equities, the better the returns are expected to be.
For many, it could be a tad difficult to comprehend the interplay between economic factors and stocks across various industries and sectors. For such people, picking stocks on their own can be a challenging task.
Some may argue that mutual funds can help in this scenario as the job of picking the right stocks and sectors gets delegated to professional fund managers. The MF route can be a proxy against direct investment in shares.
But even within the mutual fund universe, one needs to choose the instrument that best suits them. Picking the right fund can be a challenging task as they are available in a range of categories, such as large-cap, small-cap, mid-cap, thematic, flexicap, hybrid, and other funds. Each category has its own risk-return profile, which needs to be matched with the investor’s needs and goals.
Passive investing can come to the rescue of people who are looking for some handholding in terms of investing in equities, even through mutual funds.
What Are Passive Funds?
The term passive funds usually refer to index funds and exchange-traded funds (ETFs).
An index fund is pegged to a particular benchmark index and invests in the same securities that lie in the index, in the same proportion.
ETFs are close cousins of index funds. They are also passively managed funds and invest in a portfolio of index stocks in the same proportion as they figure in the index. They can be bought and sold directly on stock exchanges just like any other stocks, at real-time prices during market hours.
Passive funds are a proxy to the market. Since their portfolio mirrors a broad-based index like the Sensex or the Nifty, both in composition and weightage, they deliver returns in line with the market. So, if the Sensex rises or falls 30 percent in two years, an index fund linked to the Sensex will show an identical rise, barring a minor “tracking error”.
You may start investing in index funds or ETFs either through a lump sum or through a systematic investment plan (SIP). Remember that investing in a passive ETF fund requires you to open a demat account. That’s not mandatory in the case of index funds.
What Is Tracking Error?
Tracking error arises because passive funds charge a small amount from its unit holders towards various costs. This charge usually comprises management fees, marketing expenses, and transaction costs (impact cost and brokerage).
So, if the Sensex appreciates 10 percent during a particular period, while an index fund mirroring the Sensex rises 9 percent, the fund is said to have a tracking error of 1 percent.
While selecting an index fund, the key figure to look at is tracking error—the lower, the better.
How Do Passive Funds Benefit You?
Low Investment Amount: Passive funds can help if you want to invest in all the shares of the Nifty 50 index, in the same weight as defined by NSE, but do not have the required corpus to do so. You are not allowed to invest in stocks, fractionally. Passive funds tracking your preferred index, on the other hand, can help you invest fractionally, as per your investment amount.
Diversification At Low Cost: The Indian MF industry offers a wide range of passive funds tracking various indices, ranging from major indices to sectoral and thematic indices. You can diversify your portfolio by investing in a range of passive funds.
No Fund Manager Bias: Active fund managers may become inclined towards a particular sector or stock and may even take contrarian bets, which may or may not work out as per expectations. Passive funds involve no such bias or preference since they invest according to the specified index and there is no question of picking particular stocks or sectors.
But whether it is active or passive investing, investors need to ensure that it is as per their investment strategy and aligned with their financial goals. It is best to take such decisions in consultation with an investment advisor.
K S Rao, Head - Investor Education & Distribution Development, Aditya Birla Sun Life Asset Management Company Ltd
“Mutual funds are subject to market risks. Read all scheme-related documents carefully.”