Last week my friend reached out to me for advice. He said that he wanted to invest some amount every month to ensure that it will be of use when his newborn daughter goes to college or decides to get married. “Which fund should I invest the money in every month? I won’t touch it for at least 18 years”, he said.
I keep getting questions like this over and over again from our customers – both first-time investors in mutual funds and from those who have invested in mutual funds previously.
My two-word answer to my friend was this – ‘Passive investing’
Many of our customers at Finity are like my friend here. They are neither experts nor do they have the time for researching the best funds to invest in. They would like that decision to be left to experts.
At Finity, we have made a conscious choice to focus on low-cost passive investing products.
What is Passive Investing?
Passive investing is a buy-and-hold strategy where one invests in index funds or ETFs. These index funds or ETFs essentially mimic their benchmark indices such as Nifty50 or Sensex. For example, an index fund based on the Nifty50 index will consist of the same 50 stocks that constitute the Nifty50 index in the same proportion of their respective weights. These are also called passively managed funds. The opposite of this is an actively managed fund where the fund manager looks at beating their benchmark by picking individual stocks rather than just investing in the index.
Why Passive Investing?
Let’s look at why passive investing through index mutual funds or ETFs is one of the best ways to invest for most investors who want to stay invested for the long term.
One of the main factors that you look for while investing in a mutual fund is the expense ratio ( In simple terms, it is the cost charged by the fund house to manage your investment)
The average expense ratio for actively managed mutual funds can go up to 2.5%. This amount is charged irrespective of the performance of the fund. When you remain invested over a long period like my friend intends to, costs add up. Whereas, for a Passive investment like an index fund the average expense ratio stands at ≅0.19%. ( Certain funds like the recently launched Navi Nifty 50 Index fund has an expense ratio of just 0.06%)
There is a staggering difference in return amounts when you remain invested over a long term of 20 years. An example would help you understand this better.
Let’s consider, you invest Rs 10k per month in an index fund and an active fund. Both of which give a return of 12%. Your investment in an index fund can fetch you Rs 97.37 lakh at the end of 20 years at an expense ratio of 0.19% while the same investment in an active fund at an expense ratio of 2.5% fetches you Rs 71.75 lakh.
The difference is Rs.25 lakh.
The difference in returns could be even higher if you went in for investment in an ETF as their expense ratios are much lesser. But you would need to understand that ETFs are traded on the stock exchange and certain ETFs could be less liquid (difficult to buy and sell at all times).
The benchmark indices consist of some of the best performing and largest companies in the entire market. One of the features that every long-term investor will need to do on their portfolio is to diversify the constituents. Index funds and ETFs are by nature diversified and thereby take away that headache from the investors.
When it comes to investing or anything else, we are generally open to spending a tad higher when it comes to a better product. Are you thinking that it might be ok to spend a percent or two higher in expense ratio if that results in better performance on your investment?
So, it becomes important to check the performance track record of active funds as they aim to beat their benchmark index. S&P Global comes out with an Indices Vs Active Fund scorecard (SPIVA) that reports upon the performance of active funds versus their benchmarks.
As per S&P’s latest India scorecard, the majority of the actively managed funds especially among the large-cap, ELSS, and midcap categories failed to beat their benchmark index over the short term as well as longer-term horizons of 10 years.
This isn’t true just in India. All over the world, especially in the developed markets like the US, a majority of the large-cap funds have underperformed their benchmark for 5,10, and 20 year periods as of 31 Dec 2020,
In conclusion, passive investing is one of the best and cost-effective ways to build large amounts of wealth in the long term especially for investors who do not have the expertise or time to pick and monitor their portfolio, and who want to stay invested for the long term.
At Finity, we believe that it is important to give what is best for the investors. Passive investing is in its infancy in India while in developed markets like the USA more than 50% of all assets under management are investing in passively managed assets. We believe that for a majority of investors, passive investments should form a significant part of their investment portfolio if not entirely.
On the Finity app, you will find a separate section dedicated to passive investing. This makes it easy for our investors to research and invest in passive funds. #Go Passive.
The author is the Business Head at Finity. He is an alumnus of the Indian School of Business.