When evaluating investment options like mutual funds, individuals are typically faced with the decision between passive and active funds. Passive funds replicate existing indexes without the fund manager’s intervention, while active funds involve the fund manager actively selecting where to invest.
Passive mutual funds, commonly known as index funds, are investment schemes that aim to mirror the performance of a specific index. These funds are operated in a passive manner by fund managers, meaning they do not actively pick and choose investments but instead replicate the holdings of the designated index.
Due to their lower costs and simplified approach, passive mutual funds have garnered significant popularity among investors. Notably, the majority of actively managed mutual funds struggle to outperform their respective benchmarks. Consequently, investors are increasingly gravitating towards passive investment vehicles like index funds.
As passive funds gain traction in India, let’s know what is making these funds so popular and how should approach these funds to include them in your portfolios.
1. Both passive and active funds have their own advantages and disadvantages, leading investors to often align themselves with one approach and become ardent supporters of their chosen method on social media platforms.
2. Currently, passive investing is observing a surge in popularity within the Indian market.
3. This trend has long been established in developed markets around the world.
4. Initially, the availability of passive investment options in India was limited to just a few schemes. However, the landscape has evolved significantly, offering investors a selection of over a hundred passive schemes to consider.
What makes these funds so popular
In the past seven months of 2024, a total of 106 new fund offers (NFOs) were introduced by various mutual fund houses according to the data provided by the Association of Mutual Funds in India (AMFI). Among these NFOs, there were 25 thematic schemes and 31 index schemes.
Further examination of the data from Ace Equity MF reveals that out of these newly introduced schemes, 63 passive schemes were launched within the first seven months, compared to 51 passive schemes launched throughout the entire previous year.
“The biggest benefit of passive funds often overlooked is that they don’t have ranks, eliminating the urge to compare and react to short-term relative performance. This avoids the pitfalls of chasing toppers, making impulsive entries and exits, and feeling dissatisfied despite good absolute returns. By forgetting to analyze my passive fund for over 15 years, it became the largest part of my portfolio, even though it only made up less than 15% of my overall SIP,” said Niranjan Avasthi, Sr. Vice President & Head – Product, Marketing, Digital and Corp Communication at Edelweiss Asset Management.
“Passive funds eliminate the hassle of switching to peer funds in search of better returns. However, they require a high degree of patience and self-control, especially during market downturns. With minimal cash allocation, passive funds lack a cushion during declines. Your journey (from 15% allocation to largest portfolio holding) serves as an inspiration to stay invested, regardless of market conditions,” said Sanchit Jain, CA and mutual fund researcher.
Investment strategy
One of the key advantages of passive funds is their low cost. Since they do not require active management, they typically have lower fees compared to actively managed funds. This can result in higher returns for investors over the long term, as fees can eat into investment returns.
In addition to cost savings, passive funds also offer simplicity. Investors do not need to worry about choosing individual stocks or timing the market. By investing in a passive fund that tracks a broad market index, investors can achieve diversification and exposure to a wide range of companies with a single investment.
However, one of the drawbacks of passive funds is their lack of flexibility compared to actively managed funds. Passive funds are designed to mirror the performance of a specific index, which means they cannot take advantage of market opportunities or adjust their holdings based on market conditions.
As awareness about passive investing grows in India, more investors are beginning to appreciate the benefits of passive funds. These include lower costs, diversification, and alignment with long-term market trends. By incorporating passive funds into their investment portfolios, Indian investors can benefit from these advantages and achieve their long-term financial goals.
“The markets are becoming more and more efficient in the large cap space and the outperformance by active strategies has been declining in recent years. Given the high overlap with the index, increasing institutionalization in the large cap segment and the expense ratio differential, the active large-cap funds are finding it difficult to outperform the benchmark. At the current juncture, we prefer Index funds or passive funds tracking large cap-oriented indices that have a proven long-term record. However, in the mid and small-cap segment, we continue to prefer active funds as there are a reasonable number of funds that have outperformed the benchmark over a market cycle,” said Jiral Mehta, Senior Research Analyst, FundsIndia.
Things to note
1. When considering an Exchange-Traded Fund (ETF), it is essential to ensure that the ETF closely replicates the underlying index in terms of performance. If an index has historically generated 10% returns, investors expect the ETF’s returns to be similar. The effectiveness of this replication can be measured using the ‘Tracking Error’ metric, which indicates how closely the ETF’s performance aligns with the index. A smaller tracking error suggests a more desirable investment outcome.
2. In addition to tracking error, investors should also analyse the expense ratio associated with the ETF. Lower expense ratios are generally more advantageous for investors, as they can impact overall returns.
3. Moreover, liquidity is a crucial factor to consider when evaluating an ETF. ETFs based on market capitalization indices such as Nifty and Midcap tend to be more popular and exhibit higher trading volumes. This liquidity ensures that when investors seek to buy or sell an ETF on the exchange, there are counterparties available to execute the transactions efficiently. Sufficient trading volume in an ETF helps maintain prices close to those quoted on the exchanges, promoting a seamless trading experience for investors.
4. When purchasing Exchange-Traded Funds (ETFs) and index funds, it is crucial to take into account the overall cost of ownership. Apart from the Asset Management Company (AMC) fees, individuals are also responsible for demat charges and broker commissions. It is essential for ETF investors to be cautious of the complete cost of ownership, whereas index funds come with a combined cost of ownership, where investors solely bear the total expense ratio.
5. Passive equity funds, active equity funds, and equity shares are all subject to the same taxation rules. Short-term capital gains are applicable when assets are sold within a year of purchase. On the other hand, selling passive equity fund units after holding them for at least a year results in long-term capital gains.