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Passive Investment Myths Busted

Some of the biggest passive investment myths busted – index funds can be better and even necessary when chosen carefully from amongst many actively managed funds.
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#1 Index funds have lower returns than other mutual funds

This particular myth about index funds hasn’t held true for quite some time. Often, passive investments are at par with actively managed mutual funds.

And in some cases, they’ve even performed better. For example, take a look at the data from 2018.

Another factor to consider is that a significantly lesser amount is consumed as fees in case of index funds compared to mutual funds. In the case of active funds, the key to making a good investment and ensuring good returns is to carefully choose one out of the many thousands of choices available.

#2 ETFs are better than index funds

It is a common myth that Exchange Traded Funds are better and cheaper than index funds. But is that really so? When we consider the cost of buying ETFs, we must also consider that they need to be bought through a broker - an added hassle many may want to avoid.

The price of an ETF, while lower than an index fund, does not include:

  • Costs for brokerage,
  • Securities transaction tax (STT),
  • Demat costs and
  • Liquidity costs.

All of these can add up to nearly 1 percent. Unlike index funds, ETFs require demat accounts and are traded like stocks. Plus, Systematic Investment Plans (SIPs) cannot be set up in ETFs while they can prove to be fairly advantageous in index funds.

Of course, eventually, the choice to invest also hinges heavily on the expense ratio. But the idea that index funds are not worth it is unfounded, and it’s best we put it out of our minds.

#3 There are only two or three index funds available

This particular myth could simply have come to be due to a lack of knowledge. But there are actually much more than ten to fifteen index funds available to investors in India:

  1. The Nippon India Index Fund - Sensex Plan seems to be the top-performing fund for FY20-21,
  2. It is followed by LIC MF Index Fund Sensex and ICICI Prudential Nifty Index Fund.

The list is likely to grow dramatically in the near future as the popularity of index funds continues to scale  new heights. In fact, index funds in the US are set to surpass active fund assets by 2024, according to Moody’s Investors Service Inc. In the US, it is Fidelity ZERO Large Cap Index and Vanguard S&P 500 that have been leading the performance chart in July 2020.

In India, while Sensex and Nifty are the most popular, there are also index funds in small-cap, such as BSE SMALL CAP; mid-cap, such as Nifty Mid Cap 100; multi-cap and international funds.

#4 Index funds are for first-time investors only

Index funds are essentials that all investors should not only know about, but also consider investing in. The most sophisticated investors in developed countries invest in index funds. It’s certainly not true that these are only for first-time investors. If anything, index funds are even advised in case of retirement plans.

It is important to consider that while building a portfolio, investors generally have a strategy wherein they have a distinct core portfolio that is aimed at long-term gains and a satellite portfolio that is a smaller part. The smaller aimed at profiting from the volatile market conditions. Index funds should be a part of their core portfolio.

#5 Index funds give you returns which exactly match the index

It is untrue that index funds always give returns that match the index that it is trying to replicate. The exceptions arise mainly due to something called the tracking error. The tracking error is the standard deviation of the difference in returns between the index fund and its target index. Generally, it is indicative of how closely the index fund is following (or matching) its target index.

Conclusion

If not chosen with due care, passive investment can have their share of disadvantages. One must consider tracking error, expense ratio, and so on. At the same time, making a switch to active investment can also be worth it during a market slump. Sure, trying to pick the fund to invest in can be a tough decision and requires careful thought. But it is important to not fall for the biases stemming from myths regarding passive investment.

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