What if we tell you most of the active mutual funds cannot beat the Indices even after charging those high expense ratios? It is quite unpleasant. Why pay someone extra for underperforming the funds where there is no active fund manager? Oh, no active fund manager! Are there any funds where there is no active fund manager? Well, yes! There are such types of funds, and they are called passive funds.
We know you might have a plethora of questions at this moment about Active and Passive funds, but that is why we are here! To clear all the confusion. Let us explore all of them in detail.
Active and Passive Funds
On a broader level, Mutual funds can be classified into two categories, Active or Passive funds. The article actually roams around active vs. passive funds. Both the investment approaches differ in how the fund manager wants to invest the funds and generate returns for the investor.
Active funds are managed by a fund manager where the manager's responsibility is to manage client funds and seek to generate returns (also known as Alpha), which are higher than the benchmark index. To generate higher returns, the fund manager will do extensive research on many stocks and perform many “Buy and Sell” orders to increase his chances of generating huge returns. Since it requires in-depth analysis and research, the Fund manager and employees’ salary, Office expenses, etc., Active funds charge a higher expense ratio to cover all the costs.
Whereas passive funds try to imitate a particular Index where the fund manager will buy and hold the same constituents of stocks and give them equal weightage to the securities as in the index. This passive fund will try to generate a similar index fund return. The aim of any passive fund is not to outperform the index but to remain close to the index fund's return. Therefore, expense ratio charges, in this case, are very less as compared to Active funds as passive funds don’t have huge costs to cover.
Why are Index Funds Gaining momentum in India?
“By periodically investing in an index fund, the know-nothing investors can actually outperform most investment professionals.” This quote by Warren Buffett perfectly summarises the Index funds.
Index funds have been around for decades worldwide, but it's only in the past five years that investing in passively managed funds or Index funds has really gained momentum in emerging markets like India. Investors looking to take advantage of low-cost, broadly diversified portfolios have contributed to a lot of inflows into passively managed mutual funds.
Indeed, the biggest reason for investors investing in passive funds worldwide or mainly in developed countries is the lower expense ratio charged to the funds. Compared to the actively managed mutual funds, where the fund manager frequently buys and sells the security (churning of the portfolio), an index fund is passively managed with few transactions. Consequently, this decreases the high cost of operating a passive mutual fund. Even though when you compare the fees of passive funds with active funds, it does not seem like a big difference, but it surely adds up over time, and it shows the passive funds benefit in the longer run.
But incredibly low fees or diversified opportunities in Index funds or ETF's are not only the reason for increasing assets under management or inflows in passive funds. Let's see what the other reasons why these funds have really taken off are.
Easy access to diversified portfolios
An index fund has an inherent benefit of diversification as it mimics an index portfolio that is well-diversified among various sectors/industries. Hence, a slowdown in a particular industry will not significantly impact the fund as a whole. For an investor who wants to construct a broad, diversified portfolio at a low cost, passive funds like index funds or ETF's are ideal.
Increasing Efficiency in emerging capital markets
Active funds have been delivering returns better than passive funds for years due to inefficiency in emerging markets like the Indian market (Active vs. passive funds). Still, from the last few years, active funds have failed to beat their benchmarks. As the markets are growing and becoming efficient, active managers fail to generate Alpha, and the opportunities to exploit have reduced significantly. As a result, this is one of the reasons why investors realised the value of opting for passive funds at a much lower cost and are now shifting their funds to a passive strategy. It is probably one of the reasons that define active vs. passive funds.
Automatic Rebalancing
An Index fund goes on to track and replicate the benchmark; hence there is an automatic rebalancing that takes place without much involvement of a fund manager. Automatic portfolio rebalancing consistently tracks an index and ensures the passive funds are realigning the weighting of all the securities in an Index to perfectly match the index periodically. By getting your portfolio monitoring right, there's a better chance of reducing the cost and generating better returns for your portfolio.
The outperformance of Index funds
There has been a clear outperformance of Index funds in 2018. If active funds cannot perform better or beat their benchmarks, there is not much meaning in paying higher fees. Index funds and ETF's have started attracting investors. Another thing to note here is that the index has outperformed most of the active mutual funds across the time period. It has also become more and more difficult for active fund managers to outperform over the index constantly.
Better Apprised Investors
The immense increase in popularity of passive funds is one of the reasons why investors are switching to passive funds. The availability of information is instantaneous. Retail or small investors are better informed and aware of the value that passive strategy brings into the portfolios.
The Bottom Line
So, this was all the basics there is to know about Passive Funds. Concludingly, it can be said that this opportunity to invest in Passive funds is not something to be missed. People around the globe are reaping that benefit, and you could be one of them too. Although, the final decision to invest should be taken based on your thorough understanding of the funds.
Invest wisely!
