Passive Investing 2022 – Passive Funds Features, Benefits & Challenges
Mutual funds offer investors two types of schemes based on investment strategies: active and passive. In an active scheme, the fund manager decides which company shares to buy, how much, when, and at what price to buy. In a passive scheme, the fund manager has no say in any of the above decisions. This article will discuss passive investing – passive funds features, drawbacks & benefits.
Understanding passive investing
Every mutual fund scheme has a benchmark. An active scheme aims to outperform the benchmark, while a passive scheme mirrors the benchmark. Passive investing involves investing in all the benchmark index constituents as per their proportionate weightage in the benchmark index. Passive investing comprises index mutual fund schemes and exchange-traded funds (ETFs).
For example, the HDFC Index Fund Nifty 50 Plan has the Nifty 50 Index as its benchmark. So the scheme invests all the money in all the 50 constituents of the Nifty 50 Index. The amount of money invested in the shares of each company is in proportion to the company's weightage in the Nifty 50 Index.
Features of passive investing
The main key feature of passive investing is that it is free from fund manager bias as they don't have any say in the buy and sell decisions of the scheme. The scheme's buy and sell decisions are based on the reconstitution of the benchmark index, which usually happens once every six months.
Benefits of passive investing
Some of the benefits of passive investing include:
Low cost: There are very few buy and sell transactions in a passive fund. Also, there is no research involved to identify specific stocks for investment. Due to these reasons, the expense ratio of index funds and ETFs is lower than that of active funds. Usually, an active fund has an expense ratio in the 1-2% range, and a passive fund has an expense ratio in the 0.05-1% range. In the long run, this difference in the expense ratio can make a big difference in the overall corpus accumulated by the investor.
Diversification: Index funds and ETFs based on broader market capitalisation indices such as Nifty 50, Nifty Next 50, Mid Cap 150, and Small Cap 250 provide investors a well-diversified portfolio. For example, the Nifty 50 Index comprises 50 companies from 13 sectors (as of 31st December 2021). The mid-cap and small-cap index funds provide investors with even higher diversification.
- Low risk: The fund manager doesn't need to outperform the benchmark in an index fund. Hence, the index fund manager doesn't need to take extra risk in addition to market risk.
Challenges of passive investing
While passive investing offers many benefits, there are some drawbacks like:
Tracking error: An index fund manager always keeps some portion of the scheme money as cash to meet redemption requirements. Apart from this, some cash levels are also kept for meeting scheme-related expenses. Due to this, the scheme returns will be lower than the index returns. The difference between scheme and index returns is known as tracking error. The higher the tracking error, the lower the returns for the investor compared to the index.
Concentration risk: In the above section, we saw how an index fund or exchange-traded fund (ETF) provides the benefit of a diversified portfolio to an investor. However, within this diversified portfolio also there can be concentration risk due to the high weightages of some stocks. For example, as of 31st December 2021, in the Nifty 50 Index, the top 5 stocks constitute 41% weightage, and the top 10 stocks constitute 57% weightage. With 5-10 stocks having so much weightage increases the concentration risk.
- No choice in stock selection: Your money will be invested in all the stocks that are a part of the benchmark index. If the index has some individual stocks or stocks from specific sectors that you / scheme fund manager dislike, still there is no choice for you and the scheme fund manager to leave them out of the portfolio.
Differences between active and passive investing
Some of the differences between active and passive investing include:
|Active investing||Passive investing|
|Investment decision||The fund manager decides which stocks to buy, how much, when, and at what price to buy.||The fund manager has no say. Scheme money must be invested in all index constituents as per their weightage.|
|Objective||The objective of active investing is to outperform the benchmark.||The objective of passive investing is to mirror the benchmark.|
|Expense ratio||The expense ratio is higher than passive investing.||The expense ratio is lower than active investing.|
Passive funds are an excellent investment option for investors to fulfil their financial goals as they provide index returns at low costs. While choosing an index fund for investment, you should check the expense ratio (the lower, the better) and the tracking error (the lower, the better).
To start investing in passive mutual fund schemes as per your appropriate asset allocation, download the Glide Invest App from Google Play Store or Apple App Store and get started.