Home » How the passive funds work and the difference between active & passive funds?

How the passive funds work and the difference between active & passive funds?

How the passive funds work and the difference between active & passive funds?

Photo courtesy Alesia Kozik on Pexels.

The investment in mutual funds in India is increasing but is still small when we take the overall population into account. There are 13 crore mutual fund folios in the country and the boom in the stock markets of the last two years has led to a sharp rise in investment in mutual funds. Over the last quarter, the market has been volatile due to the oil price rise, the increase in interest rates by the central bankers around the world and the Russia-Ukraine war. Till now the flow in equity mutual funds has been steady and investors have held on to their nerves. One of the categories of mutual funds where there has been an increased awareness is the passive funds and we will dwell on these funds in detail.

There has been increasing financialization of investments and with increased digitization, it has become much easier to invest. In the past, people were interested only in investing in gold and real estate but now the situation is changing and people even from small towns have started to invest in mutual funds, which were earlier confined to the big cities. Indian mutual fund investors have mostly favored actively managed funds but now the interest and investment in passive funds are also increasing.

Passive funds invest in stocks that mirror a particular index like a Nifty or Sensex and the weight of securities is the same. The fund manager doesn’t have to do much research to pick the stocks for the portfolio and simply mimics the benchmark index. This results in returns that are close to the market returns and the portfolio is constructed to have a low tracking error.

There are two types of passive funds-

  • Index funds-

Index funds mirror the underlying benchmark index which could be based on sector, theme or market cap. The fund manager replicates the benchmark composition and the returns are almost identical to the benchmark with just a small difference that is due to the tracking error.

  • Exchange Traded funds (ETFs)-

The exchange-traded fund is a basket of securities that track an underlying index and are traded on the stock exchanges which results in their price fluctuating throughout the day. The net asset value of the stocks in the portfolio determines its value. ETFs can be traded on the stock exchange just like regular stocks. An individual should have a Demat account to trade in ETFs which is not required in index funds. The other thing is that investors can invest in index funds through a systematic investment plan (SIP) which may not be available for exchange-traded funds.

What are the things to consider before investing in passive funds?

There are a few things that the investor should consider before investing in a passive fund:-

  • Tracking Error-

Tracking error is the difference between the investment portfolio’s returns and the index it mimics. It helps to measure the performance of an investment against the benchmark over a period of time. An individual should select schemes with a low tracking error. The factors that influence the tracking error is; currency hedging, cash holding, capital gain distribution, change in the index, expense ratio, and illiquidity.

  • Total Expense ratio-

The total expense ratio (TER) is the total costs associated with managing a mutual fund which includes management fees, trading, and legal fees, auditor fees, etc. The total cost of the fund is divided by the total assets which give the percentage amount that is the total expense ratio. A scheme with a lower TER will give higher returns as compared to a scheme with a higher TER. Therefore a person should select schemes with lower TER.

  • Liquidity-

When you have ETFs you have to sell them on the stock exchange and therefore need to have buyers. If there is not sufficient liquidity you may have to sell the units at a discount to the NAV. So check for the average daily trading volumes of the ETF on the stock exchange and invest only in ETFs that have a good trading volume so as to be able to liquidate them easily.

Benefits of investing in passive funds-

There are certain benefits of investing in passive funds-

  • Low fees-

Passive funds pick the stocks according to the index they follow and after that, there is not much churning. The fund managers don’t have to do much research on the stocks and don’t need big team of analysts to do research. This results in cost savings and the expense ratios of passive funds are much lower than the active funds. Over a longer time horizon, lower costs result in much higher returns.

  • Transparency-

The assets that are there in the index fund is always clear.

  • Risk-

Active fund managers are free to research and invest in a stock which is good when they are right, but financially not good for the investors when they get it wrong.

  • Human bias-

Since the fund managers are humans there may be a certain bias in investing which is not the case with passive funds.

  • Diversification-

The benchmark indices have diversification and representation of different sectors in the market and investing in a passive strategy passes the benefits of diversification across sectors to the investors.

Difference between active and passive funds-

Investors who are happy with market returns and don’t aim for very high returns can invest in passive funds. But the investment should always be according to the risk appetite and the financial goals. Passive funds are gaining popularity in many countries and investors can certainly keep a certain part of their portfolio in passive funds.

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