Why you should consider investing in passive funds for wealth creation

It is never easy to achieve simplicity in things we do. Investments are no exception. Many retail or inexperienced investors believe handing over one’s money to professionals is a clear step towards making huge money. This again is too simplistic an assumption. Investing in markets with such a naive assumption gives rise to unfavourable experiences for first-time investors. This is one reason why investors develop biases towards investing. And, as a result, they miss out on the long-term wealth creation avenues.

Performance among Indian active managers vary across categories. According to an S&P Indices Versus Active Funds (SPIVA) report, while the S&P BSE 100 gained 6% in 2022, 87.5% of active managers underperformed the benchmark index. Underperformance rates were high over three- and five-year periods, at 96.7% and 93.8%, respectively. While active managers produced relatively better (yet not ideal) results over the 10-year period, the underperformance rate dropped to 67.9% against the funds‘ respective benchmark indices. Let us understand the advantages of investing in passive funds, but first let’s discuss some basics.

Passive funds: Passive funds like index funds and exchange-traded funds (ETFs) are mutual fund schemes that replicate the value of an underlying, which could be an index or a commodity. It must be noted here that units of ETFs are listed on an exchange, while index funds buy a basket of stocks which are constituents of the underlying index in the same proportion that they represent in the index.

No human bias: Many investors invest in markets with a hope that they will pocket top-of-the-chart returns. However, it is not easy to make money, especially in risky assets such as stocks. Even professional hands find it difficult. The findings of the SPIVA report reflects this aspect of active investing. Passive investing, hence, becomes an important strategy in the world of investing. On a fundamental level, fund managers’ quest to beat the market is done away with in passive investments. Passive fund aims to mimic the constitution of the benchmark index, and deliver similar returns.

Simplicity: Passive investments are simpler to administer and track than mutual funds with an active management: a fund manager sticks to the underlying index, and rebalances the scheme only when there are changes in the underlying index, which may change the index constituents based on a transparent index methodology.

Returns: For the long-term, in a growing economy such as India, equities tend to do well. Broad-based indices tend to capture this positive sentiment and can become a very simple instrument to participate in the growth story of the economy.

Cost-efficient: Actively-managed equity funds can charge up to 225 basis points of the assets for managing an active investment scheme. Index funds can charge up to 100 basis points. ETFs tracking popular broad based index like the Nifty 50 charge as low as 5 basis points. However, while investing in an Index fund or an ETF, investors have to be watchful of a few key factors such as the volumes of ETF on stock exchange, impact cost, tracking error and expense ratio, depending on the format they choose. Tracking error explains how closely a fund manager mimics an underlying index—lower the better. An index fund or ETF with low cost and low tracking error can save a lot in the long-term.

Diversification: Besides, most passively-managed mutual fund schemes provide diversification. Most broad-based indices are nothing but large basket of stocks, that ensures no single stock influences a portfolio’s return.

Picking passive funds: Considering these advantages, investors must add passive funds to their portfolios. Staggered investments in ETFs or index funds can help investors reduce the timing risk considerably.

An investor’s core portfolio might include schemes that track large-cap-focused broad based indices such as the Nifty 50 Index or Nifty Next 50 Index. Aggressive investors may allocate some money to mid-cap indices like the Nifty Midcap150 index, while savvy and experienced investors can also allocate money to index funds tracking themes or sectors as a part of their satellite allocation. Following the core and satellite strategy, investors can create a portfolio which can provide reasonably good returns in the long-term.

Hemen Bhatia is head of ETF at Nippon India Mutual Fund.