A guide to invest in passive funds

The World is steadily unlocking itself from the coronavirus crisis, but the economic disruptions continue owing to multiple reasons, including reverse migration of the workers.

While we are yet to flatten the curve for COVID-19 cases, the curve for economic activity had fallen quite sharply due to the lockdown situation. As laid down in its recent policy statement, the Monetary Policy Committee of Reserve Bank of India also expects the economic growth to dip during the current fiscal. However, the economic impact of these disruptions continues to be a mystery for many sectors as well as companies.

Given the uncertainty prevailing across the sectors, the investors would prefer to invest across a basket of stocks, instead of betting in specific companies.

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Benchmark indices are built through robust statistical methodologies to be a fair representation of various sectors in the economy. Such indices are not only created in that manner but also reviewed regularly based on various dynamic parameters.

As such, investing in the index can be one of the prudent investment strategies in terms of portfolio diversification and long term wealth creation.

However, indices are not a tradeable security by themselves, and replicating the index composition within the investment portfolio can be a costly affair, not only in terms of capital investment but also on time invested in tracking such indices.

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Passive funds come to the rescue of such investors, helping the investors to have similar investment exposure conveniently. While the investors may be looking out for excitement beyond the benchmark indices, one must instead stay focused on the benchmarks themselves as the generation of alpha during the current uncertain times might be difficult.

Passive funds also help in the reduction of portfolio risk for the investors in a simplified manner by the elimination of unsystematic risk. To put this into context, the investment risk can be broadly classified into systematic and unsystematic risk, wherein systematic risk refers to the risk of macroeconomic changes wherein the investor or the investment may not have any significant control.

The best example of such risks in investing is the situation we are currently facing, i.e., the coronavirus crisis leading to a slowdown in global economies. However, the other kinds of risks are the unsystematic risks, i.e., the risk of choosing the wrong investment within the portfolio.

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When there is a cloud of uncertainty around, it is the best strategy to invest in passive funds and mitigate such risks. The fund manager does not play an active role in investment decisions and only tracks the underlying indices for any changes to replicate the same in the portfolio.

Another significant advantage of investing in passive funds is in terms of simplification. While the current conversations may be full of medical jargon due to over-exposure of such terms through news and media, it is always preferable if the investment portfolio stays simplified and decluttered.

Read: Global cues, coronavirus trend to be major drivers for markets this week: Analysts

Having a similar portfolio like that of a benchmark index helps the investors in terms of tracking the performance easily. This is because the underlying indices are often talked about in the news, giving a fair idea to the investor regarding the direction where the returns are headed.

The fund managers do not enjoy any flexibility or discretion in terms of selecting the portfolio stocks or their weightage in the investment portfolio. Without any active fund management, the lower fund management charges help the Total Expense Ratio (TER) to stay low, thereby enabling a cost-effective investment solution for the investors seeking broader market exposure.

Subject to tracking error, the returns generated by the funds will replicate the returns generated by the underlying index. As such, these funds generate index like returns at a cost that is much lower than actively managed funds.

Passive investing appears to be a win-win for all stakeholders. As such, passive investment products like index funds, index ETFs, etc. can be considered as an ideal product for investors looking for something simple, cost-effective, and long-term effects concerning returns.

(The writer is ED and CEO, Nippon India Mutual Fund)