Simplifying Mutual Funds

Passive Investing is an investment strategy that aims to maximize returns by minimal trading in the market. Reducing the number of transactions gives a huge cost advantage to the investors. This method of investing advocates a long term buy and hold strategy and goes by the logic that markets move up over longer periods of time. Passive investing can be adopted for a single asset class such as equity or for a combination of the asset classes like equity, debt, commodities, etc.There are many avenues for adopting passive investing, one of the popular and the easiest ways of following passive investing is investing in the Index mutual funds (Nifty, Sensex, etc) where the fund looks at buying and holding the constituents of the index and matching the returns of the index.

In developed markets like the US passive investment products acount for almost half of the investments in equity markets.

Active Investing is a form of investing where the fund manager is actively involved in picking the stocks for the mutual fund portfolio of any particular fund. This may involve in multiple buy/sell transactions based on the market conditions which adds to the cost of the fund management. Active investing also aims at beating benchmark returns by actively managing the fund.

On the other hand, passive investing is a long term buy and hold strategy which aims at mirroring the index and reducing buy/sell transactions by the fund manager for maximum gains. Passively managed funds look at generating returns in line with their benchmark index.

Index fund is just like any other mutual fund, but the portfolio of an index fund mirrors or replicates an index such as Sensex,NIfty, etc. These funds invest only in the components stocks of the Index that it tracks, irrespective of the market conditions. The fund manager does not actively select any other stocks for investment. The components or portfolio of any Index does not change frequently, so Index funds essentially buy and hold these stocks in the Index. These funds change their portfolio only when there is a change in the constituents of the Index which is why they have a lower expense ratio. When the expense ratio is lower, investors have higher chances of maximising returns on their investments.

The portfolio of Passive investment instruments like Index funds replicate the portfolio of the index they track. These funds also aim to match the returns of the index they mirror. So in an ideal scenario, the returns on the fund and the index should be same, but they could end up being different which is measured through the tracking error.Tracking error is the difference between the returns on an Index and the returns on the fund that aims to replicate the Index. The lesser the tracking error, the more efficient the fund. This is one of the factors that could help you choose an index fund for investment.

Expense ratio is the fee charged by the AMC on its assets under administration for providing fund management and other services to the investor. Expenses like fund manager salaries and other costs like transactions charges, custodian charges,brokerage are some of the expenses charged. An expense ratio is expressed as a percentage of the fund invested. This percentage is deducted from your investment irrespective of the performance of the fund. For example: If you make an investment of Rs 1000 in a fund with expense ratio of 2%, only Rs 980 will be invested and Rs 20 will be retained by the AMC for their expenses.

So, a lower expense ratio as in Index funds or direct mutual funds helps investors maximize their returns,A difference of even a percent in expense ratio can make a lot of difference to the returns earned over longer periods of time.

Direct mutual funds are mutual funds offered directly by the AMC or Zero commission Zero Fee App investment platform like Finity, so no distribution fee or commission is payable to any third party. Whereas, regular mutual funds are sold through agents, distributors, third party websites, etc. When you invest in a regular mutual fund, a commission/distribution fee is paid to agents/distributors/third party. This forms a part of the expense ratio of regular mutual funds which is deducted from your invested amount. So expense ratio of a regular mutual fund is higher than that of a direct mutual funds.

Lower expense ratio enables investors to maximize returns. For more on expense ratio - Pls refer the FAQ on Expense Ratio above.