Your Money: Why investing in passive mutual funds is a must

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Education loans can be taken for self, spouse, children or student for whom you are the legal guardian.

Mutual funds are one of the best market-linked investment vehicles for investors. Generally, they offer diversification of risk with the potential to generate high returns in the long-term. However, often investors get confused about where to invest their hard-earned money, especially given the variety of funds currently available in the market. Let us discuss passive mutual funds and why investors may consider the same as part of their portfolio.

What is a passive mutual fund?

In the case of an active mutual fund, it is managed by a fund manager who is responsible for doing research to select shares, proportion of investment in each stock / sector, monitor the performance of the fund, periodic balancing, etc. However, in case of a passive mutual fund, the fund manager does not perform all the above activities, especially stock selection as mutual funds construct their portfolio by tracking a market index or a specific market segment. Unlike active funds, there is no need to do any research to identify the stocks to be part of the fund portfolio. The fund manager simply constructs the portfolio by mimicking the index composition. Thus, the returns are close to the market returns.

Types of passive funds

Exchange traded funds (ETFs) are a type of passive funds wherein the ETFs are pooled investments which are created to track the benchmark index or sector. Another type is that of index funds which are created to replicate a specific index or sub -index or sector. It could also be of Fund of Funds (FoF), which are mutual funds that invest in the units of other mutual funds, rather than buying different types of securities such as shares, bonds, etc., themselves. Finally, it could be smart beta funds which are an extension of ETFs that do not aim to just replicate an index but to select the individual securities based on various parameters such as volatility, value, growth and momentum. Smart beta ETFs are actually a mix of passive investing approaches with some elements of active selection.

The advantages and limitations

To understand whether the passive investment funds are right for you, you need to know the advantages and limitations of the same. The major advantage of passive funds is that they have lower expense ratios, and no human bias will get reflected into the stock selection, besides better transparency and ease of investment. However, the major limitation of passive funds is that they have no potential to out-perform the market as they are simply tracking the index/benchmark itself.

For instance, an active fund manager may take investment calls and adjust the weightage of the shares in the portfolio according to their convictions to beat the benchmark index which is not feasible in passive funds.

Risks and returns

Passive funds are riskier because they are market-linked securities. Thus, any swings in the index will have a great impact. Investments in any type of mutual fund whether it is active or passive are subject to market risk. So, investors must choose the index funds / ETFs that provide suitable risk-to-reward opportunities.

Passive funds take out the element of active portfolio calls taken by the fund management team, but the money is still invested in stocks. So, when the equity market sees a correction the market values of passive equity funds will also fall. At the same time, risk levels are far lower than that of those of actively managed funds.

The investment goal of passive mutual funds is to closely resemble the benchmark index, such as the Sensex or Nifty.

To conclude, if an investor’s investment objective is long-term, one can achieve benchmark returns because the very objective of the passive fund is to generate benchmark returns as closely as feasible.

The writer is a professor of finance & accounting at IIM Tiruchirappalli.