Over the past few years, India’s mutual fund industry has started adopting a trend already widely prevalent in the more mature markets of the Western world, such as the US and Europe. That trend is the use of index funds or what is also known as passive investing.
Passive investing might be just right for you if you have recently started exploring the world of mutual funds but don’t know how to start making investments.
Passive investing might also be right for you if you are already investing in some mutual fund schemes but are dissatisfied for some reason and now want a simpler and cheaper option.
And if you have been investing in mutual funds for a long time but have accumulated far too many schemes over the years, passive investing might be right for you, too.
In short, passive investing can be just right for almost everyone.
But how do you build a portfolio of mutual funds to create wealth through passive investing? Here are some tips.
What is passive investing?
In mutual fund investing, there are two main investment approaches one could follow – active and passive.
Active investing is choosing schemes where a fund manager decides what stocks to buy and sell.
Passive investing, or index investing, refers to an investment strategy where the fund mirrors a capital market index and invests the money collected from investors in the same stocks that make up the index and in the same ratio.
A passively managed fund, therefore, doesn’t require a fund manager and just follows a predetermined set of rules. Since passive index funds don’t need a fund manager, fund houses generally charge a far lower fee for such schemes than actively managed ones.
There are other benefits of passive investing, too. They are simpler and easier to understand. For instance, a Sensex index fund invests in the same set of 30 companies that comprise the BSE benchmark and the Nifty 50 index fund invests in the 50 companies that are part of the Nifty index on the National Stock Exchange. Similarly, there are other indices such as the Nifty Midcap 100, Nifty Small-cap 250 and so on.
As a result, the returns generated by index funds are similar to those of their underlying index, subject to fund expenses and a tracking error.
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Passive investing strategies
Mutual fund houses offer broadly two types of passively managed schemes: Index funds and exchange-traded funds, or ETFs. Both sets of funds track an underlying index. So, from a passive investing viewpoint, both can be considered.
However, there are a couple of differences between the two. The main difference is that ETFs, as the name suggests, are traded on a stock exchange while index funds are not. Since ETFs are bought and sold on an exchange, investors need a demat account and a trading account to invest in these products.
Index funds don’t require a demat account. On their own, ETFs carry a lower expense fee than index funds, but that’s before taking account fees for demat and trading accounts, brokerage costs etc.
Moreover, some ETFs may not have enough liquidity on an exchange. This could make it difficult for investors to buy or sell ETFs.
In general, therefore, index funds are often a simpler option for retail investors while institutional investors or high-net-worth investors can look at ETFs, too.
Things to check before building a portfolio
Now that the basics of passive investing are clear, let’s take a look at a few factors one should evaluate before setting out to build a passive investment portfolio.
1/ Risk assessment
This is one of the first things an investor should do. Equity investments by their very nature are risky, so each person should think carefully how much risk can they take and decide whether they are conservative investors, moderate or aggressive.
2/ Asset allocation
Investors should decide the amount or proportion of their wealth or surplus income that they want to invest in mutual funds or other asset classes such as gold or real estate. Within mutual funds, too, they should decide the asset allocation they are most comfortable with. They should also decide what proportion to invest in large-cap index funds, midcaps or smallcaps.
3/ Investment horizon
The likely holding period of the investment is important to decide what funds to choose. For instance, if the investor needs the money back after a couple of years, investing in debt is more prudent. One should choose equity funds only if the goal for which one is investing is at least five years away.
Building a passive investment portfolio
Index funds come in various shapes and sizes. Funds can be divided on the basis of market capitalisation of stocks, sectors, investing themes, geography or other factors such as quality of stocks, volatility, and momentum.
To be sure, most people may not need all types of funds in their portfolio. In fact, they should try to keep their portfolio as simple as possible and choose three to five funds only. This is, however, not a general recommendation and one should assess their own financial situation. Investors with a relatively small pool of capital may, for instance, need only one or two funds while those with more money to invest can add a few more schemes.
Before choosing a fund, investors should check a few parameters – the size of the fund, the total expense ratio and the tracking error – and compare a few schemes of the same category.
1. Large-cap index funds and ETFs
Investors should keep a substantial portion of their money in large-cap funds such as the Nifty 50, Sensex and Nifty 100 funds. Those who can take a little more risk can also put in some money in Nifty Next 50 funds. Investors can also explore equal-weight index funds where each stock has the same weightage, unlike market capitalisation-based funds that are more popular.
2. Mid-cap index funds
Mid-cap stocks and funds are typically more volatile than large-caps, though they can also be more rewarding. Investors with a higher risk appetite and a longer investment horizon can consider these funds. These include the Nifty Midcap 150, Nifty Midcap 100, Nifty Midcap 50 and the factor index Nifty Midcap 150 Quality 50, which is made up of 50 high-quality stocks from the Nifty Midcap 150 universe.
3. Small-cap index funds
Funds that track the BSE Small-Cap index or the Nifty Small-Cap 250 are even more volatile than mid-cap funds, and so are not for everyone. Even if early investors do select this category, they should keep their exposure limited.
4. Sectoral funds
These funds track indices of a particular sector, such as automobiles, banks, IT and pharmaceuticals. These funds are less preferable than diversified schemes such as the Nifty 50.
5. International funds and ETFs
Investors who want to diversify their investments across regions can consider these funds. The most popular international index funds are those that invest in the US market, particularly the S&P 500 diversified index fund and the tech-heavy NASDAQ.
6. Factor-based index funds
Many fund houses have launched index funds comprising stocks selected on the basis of certain factors such as low volatility, high quality and high momentum. However, this is a new space and investors should thoroughly evaluate such schemes before investing.
Summing up
Mutual fund investors have multiple options to build their portfolio using a passive investing strategy. Index funds and ETFs are not only cheaper than actively managed funds but also take away the fund manager performance risk.
While the downside is that index funds and ETFs don’t outperform actively managed funds, the upside is their performance is more consistent in the long run.
Investors should evaluate all the parameters carefully before building a portfolio. Most investors would do well to focus mainly on large-cap funds while those with higher risk tolerance, a bigger corpus to invest and longer investment duration can also consider other type of funds.
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