What is passive (or Index) investing?

Passive Funds

Passive Investing is a strategy that seeks to maximize returns by minimizing trading. Followers of this philosophy believe that it is not possible to continuously beat the market, especially in the long run. Hence, constant buying and selling is unnecessary and returns eroding activity. 

Passive Funds, thus, are mutual funds which invest in the same stocks like that of the underlying index and seek to achieve similar returns as that index. Examples of passive investing are Index Funds and Exchange Traded Funds (ETFs).

 

Benefits of Passive Investing

 

1/ Low Cost

 

Fund managers of passive funds do not need to proactively monitor the market or take investment related decisions. As a result, these funds charge lower management fees. Lower fees mean higher returns for you.

 

2/ Transparent

 

As an investor, you have complete clarity on the stocks that the fund will invest in. There is no scope for ambiguity.

 

3/ Simplicity

 

Unlike actively managed funds which require a dynamic strategy, constant market research and alterations, life is simpler with passive funds. 

 

History of Passive Funds in India

According to a report by Morningstar, in the United States, the AUM of passive funds has surpassed that of actively managed funds in 2019. However, for India passive investing is a concept which is yet to become a household name. Despite a healthy performance track record, passive investing is yet to gain solid momentum in India. Index Funds and ETFs form a mere 6.5% of the country’s total mutual fund assets.  

 

Percentage of Funds outperformed by the Index 

Category Comparison Index 1-Year 3-Year 5-Year 10-Year
Large-Cap S&P BSE 100 76.67% 82.93% 65.71% 61.34%
Tax Saving (ELSS) S&P BSE 200 80.95% 83.33% 51.35% 45.71%
Mid-Small Cap S&P BSE 400 MidsmallCap Index 18.92% 47.83% 26.98% 48.84%
Govt. Bond S&P BSE India Government Bond Index 76.92% 73.17% 84.62% 87.72%
Composite Bond S&P BSE India Bond Index 98.57% 94.2% 97.64% 96.10%

(Source:  S&P Dow Jones Indices, Morningstar and AMFI)

 

One major factor that is responsible for this slow growth of passive investing is the interest deficiency from distributors. For a country in which a majority of the retail investors depend on a broker, passive funds low expense ratio and thus low commissions create a conflict of interest i.e brokers rarely recommend them. 

 

Some commonly asked questions on passive investing 

 

Q/ Can index and active funds co-exist in one portfolio?

 

A: Yes they can, but given the international and Indian evidence on passive outperformance you have to be really clear why you want to invest in active funds. 

 

 

Q/ Are index funds suitable for a novice or a seasoned investor?

 

A: Yes, they are suitable for all investors. Low cost investing is good for everyone, be it a novice or a seasoned investor. 

 

 

Q/ Isn’t passive investing riskier than active investing? Fund managers do not have the flexibility to change the allocation even if one of the stocks is under-performing.

 

A: Like any investment, index investing is also subject to overall market-risk. For instance, index funds track a certain benchmark or indices. So, when the latter falls, the value of Index Funds will also go down. However, compared to actively managed funds, they face less volatility.

 

Interested in how we think about the markets?

Read more: Zen And The Art Of Investing

 

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5 Responses

  • vandhi

    March 5, 2020 AT 02:19

    Please include one more in FAQ, Is Downside protection missing in Passive funds and available in Active funds. This is the one area, where active fund managers are making betting against Passive funds.


    • Sushanta

      March 9, 2020 AT 18:56

      There is no downside protection in passive/index funds. That is why these funds are cheaper. Active funds are supposed to give protection to market falls and also expected to beat the index and that is why TER is higher. However very less fund managers are able to do the same and so focus is shifting again to index investing.


  • Ramneek

    March 23, 2020 AT 18:00

    I noticed there are times when a highly established fund like SBI Nifty 50 ETF delivers significantly different returns than the Nifty 50 index itself. For Eg: the ETF delivered -6.95% on 23 Mar compared to Nifty index which delivered close to -13% . Wonder why would such an anomaly persist?


  • ronak matta

    March 28, 2020 AT 07:46

    please suggest some good passive funds