Take for example the example of Arun Sharma. Twenty years ago when he started his financial planning journey, he was aware of only two investment options which were bank fixed deposits and equities. One offered fixed but relatively low returns that were often not even able to beat inflation. Equities, on the other hand, offered the potential to generate strong returns over time, but came with higher risks. Because of these factors, investors either end up investing most of their investments in low-yield and low-risk fixed income investments or potentially high-yield and high-risk equities. Similar was the case of Arun too. He had only these two options and in the end made a sub-optimal investment decision. However, today, when his 25-year-old nephew, Sid, begins his investing journey, he is spoiled for choice. He need not choose from the two extreme ends of the spectrum, i.e. high risk and high return or low risk and low return. There is a middle way, called passive investing, which can help it generate good returns without incurring proportionate risk or paying the high cost of active investing. In fact, Sid isn’t the only one actively considering investing in a passive way. An increasing number of investors in India are now turning to passive investing.
Let’s see what the numbers are telling us. The amount being invested in passive schemes is increasing. Exactly a year ago, in January 2020, the total amount invested in index funds and ETFs stood at Rs 8,082 crore and Rs 1,84,534 crore respectively. However, in just one year, till May 2021, the amount increased to Rs 22,904 crore and Rs 3,16,289 crore, registering an astonishing growth of 183 per cent and 71 per cent respectively. However, it is still a drop in the sea compared to the fact that the total amount invested in mutual funds at present is around Rs 37,40,791 crore. It also points to a huge opportunity for passive investment to grow in India.
So, what exactly is passive investing and why is it so attractive?
Passive investing is a strategy that involves buying all the stocks or other securities in an index. Passive fund managers buy securities in the benchmark index in the same proportion as the index, and then hold the securities until there is some rebalancing in the index. The main objective of a passive investment strategy is to generate returns that are similar to the returns generated by an index or basket of securities. Unlike active fund managers, who seek to outperform the market, passive fund managers seek to outperform the market. There are some very clear benefits of passive investing. This includes:
- Less cost: Since the main objective of passive investing is to perform in line with the benchmark and not outperform the benchmark, fund managers do not need to spend a lot of time and energy in research and stock selection. Therefore, fund manager fees are usually quite low. Furthermore, due to its slow and stable approach and low trading, transaction costs are also low. As a result, the fees you pay to passive fund managers are relatively low as compared to active fund managers.
- Miscellaneous Holdings: Since passive investing typically involves investing in benchmark indices, portfolios created through such a route are often well diversified. Generally, if you want to achieve diversification you need to buy multiple securities belonging to different sectors. However, if you follow passive investing, you can achieve portfolio diversification through just one investment in a fairly efficient and low-cost manner.
- low risk: It is well known that diversification is a great way to reduce portfolio risk. Thus, passive funds can help you reduce portfolio risk along with achieving diversification. In addition, investors can choose to optimize the diversification benefits of passive investing by investing a range of passive funds across different asset classes, such as debt and equities, across disciplines and sectors.
How can Arun, Sid and many investors like them take advantage of passive investing?
An individual equity investor can create a passively managed portfolio by purchasing all index stocks in the same proportion as the index and then holding them for a long period of time. By doing this the investor will be able to replicate the index returns. However, this can be challenging as the individual investor will need to track index changes in terms of composition, weighting and corporate action and ensure that these changes are reflected in his or her portfolio. This can be a complicated and tedious process.
Thus, an easy way to follow a passive investing strategy is to buy an index fund directly. These are mutual fund schemes that buy all the shares or components of a specified benchmark index in the same proportion as the index. The fund manager ensures that the performance of the scheme mimics the performance of the index. These can be easily purchased directly from the Asset Management Company (AMC), distributors or online platforms. The biggest advantage of index funds is that the cost of such funds is very low. This is because, unlike an active fund manager, a passive fund manager is not required to do a lot of in-depth research and select the best securities for the portfolio. The good thing is that today you can choose to invest passively in multiple asset classes including debt, equity and gold.
The bottom line is that investors today do not need to compromise when making investment decisions. They have a wide range of options and can easily choose the products that best suit their risk return requirements. While all investment decisions should ideally be made from the perspective of the individual’s risk-return needs and investment time horizon, each investor may consider allocating a smaller portion of their portfolio to select passive funds.
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