Passive Mutual Funds: A Guide To Getting Started

Investing in passive mutual funds is a great option for those who want a low-maintenance way to invest in a portfolio of assets. Passive funds are a type of investment vehicle that tracks a market index or market segment to determine what to invest in, rather than relying on a fund manager to decide. This makes them cheaper to invest in than active funds, as there are no costs involved in stock selection and research. Passive funds are also beneficial due to their ease of trade and high level of transparency. However, it's important to remember that passive funds are considered high-risk investments, and investors could lose all their money.

Understanding the difference between passive and active funds

Passive and active funds are two distinct investment strategies that cater to different investor preferences and financial goals. Here's a detailed breakdown of the differences between the two:

Nature

Passive funds are more static and rigid in their approach. They are designed to replicate the performance of a specific market index, such as the S&P 500 or the FTSE 100. The fund manager does not actively choose the stocks or securities; instead, the portfolio follows a set of rules to match the composition and weightage of the chosen index. This makes passive funds cheaper to invest in due to lower fees. Examples of passive funds include tracker funds, exchange-traded funds (ETFs), and index funds.

On the other hand, active funds are more dynamic and flexible. They aim to outperform a benchmark index, such as the Nifty 50 or the Sensex, by leveraging the expertise of professional fund managers. These fund managers actively select stocks, time the market, and allocate assets based on their research and analysis. Active funds strive for higher returns but come with higher costs and risks.

Expense Ratio

The expense ratio, expressed as a percentage of the fund's assets under management (AUM), is generally lower for passive funds. This is because passive funds have lower operational and transaction costs since they do not require active intervention by a fund manager. In contrast, active funds have higher expense ratios due to the fund manager's research, analysis, and management efforts.

Risk

Passive funds carry market-level risks and tend to have lower volatility and tracking error. By closely mirroring an index, they eliminate the human factor, reducing the risk associated with the fund manager's skill, judgment, and potential errors.

Active funds, on the other hand, have higher risks. Their performance depends on the fund manager's abilities and decisions, which introduces additional risk.

Returns

Passive funds offer steady, long-term returns that closely follow the benchmark index. Investors can expect market-aligned returns, although passive funds may not generate substantial alpha.

Active funds, in contrast, strive for higher returns and aim to surpass their benchmark index. However, this is not always guaranteed, and active funds may sometimes underperform the market.

Diversification

Both active and passive funds offer diversification, but their approaches differ. Active funds may take more concentrated positions in specific stocks or sectors to generate alpha, which can increase risk. Passive funds, meanwhile, typically maintain broad exposure to the entire market or index, leading to lower risk levels.

Market Conditions

Market conditions can influence the relative performance of active and passive funds. During periods of high volatility or low stock correlations, active funds may have more opportunities to add value through stock selection and tactical asset allocation. On the other hand, passive funds may outperform in low-volatility or high-correlation periods due to their low costs and broad market exposure.

Weighing the pros and cons of passive investing

Passive investing is an investment strategy that aims to maximise returns by minimising the costs of buying and selling securities. It is typically done by investing in a mutual fund or exchange-traded fund (ETF) that mimics the index's holdings. This strategy is less expensive and complex than active management and often produces superior after-tax results over medium to long time horizons.

Pros of passive investing

• Lower fees: Relying on rigid formulas to pick securities eliminates costly research, so index funds tend to be less expensive to operate than actively managed funds.
• Transparency: It's clear which assets are in an index fund.
• Tax efficiency: Index funds that use a buy-and-hold strategy typically generate low or no taxable capital gains annually for shareholders.
• Simplicity: Owning an index, or group of indices, is far easier to implement and understand than a dynamic strategy that requires constant research and adjustment.

Cons of passive investing

• Lack of flexibility: Passive funds are limited to a specific index or predetermined set of investments. They typically are allowed to make few, if any, changes. Thus, investors are locked into those holdings, no matter what happens in the market.
• Smaller potential returns: Passive funds pretty much never beat their index, even during times of turmoil, as their core holdings are locked in to track the market.

Passive investing has pros and cons when compared to active management. Passive strategies can have lower fees and greater tax efficiency, but they can result in smaller short-term returns compared to active investing. Passive investment can be an attractive option for hands-off investors who want returns with less risk over a longer period of time.

Recognising the risks of passive funds

Passive funds are a great investment vehicle for those who want to invest in a portfolio of assets but don't want to spend time and effort picking out the investments themselves. They are also ideal for new investors who are unaware of the dynamics and risks of the stock market. However, it is important to recognise the risks associated with passive funds.

Firstly, passive funds carry the risk of losing all your invested money. Start-up businesses have a high failure rate, and if the business you invest in fails, you will likely lose your entire investment. This risk is heightened as you are unlikely to be protected by regulatory bodies if something goes wrong. For instance, the Financial Services Compensation Scheme (FSCS) does not cover poor investment performance.

Secondly, passive funds lack flexibility. Fund managers are usually prohibited from taking defensive measures, such as reducing investment in a particular security, even if they anticipate a decline in its performance. This lack of flexibility can lead to reduced returns compared to actively managed funds, which have the freedom to adapt to market conditions.

Another significant risk is over-exposure to a small number of sectors or stocks. Passive funds automatically follow the best-performing opportunities, resulting in portfolios heavily weighted towards a few high-performing investments. If these investments suddenly underperform, it can cause the overall portfolio value to plummet.

Additionally, passive funds may take a long time to pay out. Even if your investments are successful, it could take several years to get your money back. Selling your investment early is often not an option, and the most common way to retrieve your money is through the business being bought out or going public, which is uncommon for start-ups.

Finally, the value of your investment can decrease if the business issues more shares. If the business grows and issues new shares with additional rights, such as fixed dividends, your relative ownership percentage decreases, and your chances of a return on investment diminish.

It is important to remember that passive funds are considered high-risk investments by financial authorities, and you should be prepared to lose all your money. To mitigate these risks, it is advisable to diversify your investments and not allocate more than 10% of your money to high-risk ventures.

Knowing the types of passive funds

Passive funds are of two main types: index funds and exchange-traded funds (ETFs).

Index funds are open-ended schemes where investors buy and redeem units of mutual funds at net-asset values. The performance of an index fund is dependent on the performance of a particular index, such as the S&P 500 or FTSE 100. The fund's portfolio contains shares in similar proportions to the index it tracks. For example, if the S&P 500 rises or falls, so does the passive fund.

Exchange-traded funds (ETFs) are another type of passive fund. The units of ETFs are listed on a stock exchange, and investors buy and sell these units in real time through a Demat account. ETFs can be bought and sold at any time during the trading day, and they offer high transparency by showing all underlying assets.

Other types of passive funds include tracker funds, which fall under the broader category of passive funds as they track an index.

Comparing the costs of active and passive funds

Passive funds are generally considered to be a low-cost option for investors. They are cheaper to invest in than active funds because they do not require a fund manager to spend time actively researching and analysing investment opportunities. Passive funds simply track a market index or a specific market segment, and this lack of analysis means lower fees. Passive funds also benefit from an ease of trade and a high level of transparency, as investors know at all times what stocks or bonds an indexed investment contains.

Passive funds are also considered to be tax-efficient. As they follow a buy-and-hold strategy, they do not typically trigger a large capital gains tax for the year.

However, passive funds are limited to a specific index or predetermined set of investments, so investors are locked into those holdings no matter what happens in the market. They also rarely beat the market in terms of returns, as their core holdings are locked in to track the market.

Actively managed funds, on the other hand, require paying a healthy fee to the fund manager for their extensive research and analysis. These fees are higher because of the transaction costs incurred by all the active buying and selling, as well as the salaries of the analyst team.

Over the years, only a minority of actively managed funds have beaten the market. For example, over a recent 10-year period, active mutual fund managers' returns trailed passive funds consistently. On an after-tax basis, managers of stock funds for large- and mid-sized companies produced lower returns than their index-style competitors 97% of the time, while managers of small-cap stocks trailed 77% of the time.

Despite this, active funds have their advantages. They offer more flexibility as managers are not required to follow a specific index, and they can buy those "diamond in the rough" stocks they believe they've found. Active managers can also hedge their bets using various techniques, such as short sales or put options, and they can exit specific stocks or sectors when the risks become too big. They can also employ tax management strategies, such as selling investments that are losing money to offset the taxes on winning investments.

However, the higher fees of active funds can kill returns over time, and the extensive analysis and expertise required of fund managers do not always pay off in terms of market-beating performance.

Frequently asked questions