Why Passive Funds May Gain Traction?

  • Akarshita Yaji
  • Jul 28 2021
  • 6 minutes
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Investors have a wide range of investments to choose from – ranging from mutual funds to equities, to debt instruments to sovereign gold bonds. But the mutual fund market has been seeing steady growth over time, and of late, passive mutual funds have gained quite some traction in the market. Wondering why this is the case? Read on to find out!

What are Passive Mutual Funds?

A passive fund is a type of mutual fund that tracks a market index to get maximum gains out of it. 

The fund manager does not actively select the portfolio of the fund. He or she only has the job of reducing tracking error or deviation of the funds return from the index return. by mirroring the index the fund tracks. 

Passive funds are a good place to start for investors who have minimal knowledge about the mutual fund market and wish to test the waters before diving in deep. Investing in passive funds works well as the investment is in an Index so the investor is very clear about the components of the portfolio. 

Types of Passive Funds

Index Funds – it is an open-ended scheme where the investors buy and redeem units of the Mutual Funds at its NAV. It is dependent on the performance of a particular index like Sensex or Nifty that it looks to mirror and they contain shares in a similar proportion as in the case of a particular index. 

Exchange Traded Funds (ETFs) – units of exchange-traded funds are funds that mirror the index but are listed on a stock exchange that investors can buy and sell units at real-time prices through their Demat account.

What are Active Funds?

The fund manager will take decisions about which stocks must belong to the portfolio. There is a relatively higher fee that is charged for active funds as the skills of the analysts, researchers and fund managers demand a premium.  Also, actively managed funds look at beating their benchmark through active stock selection. 

This holds true for Equity mutual funds, debt mutual funds, hybrid funds, or fund of funds.

What are the differences Between active and passive Investing?

ParticularsActive investingPassive investing
Meaning The fund manager actively changes the fund’s composition or portfolio at his or her discretion according to the market movements.The fund manager only copies the movement of the benchmark indices.
ReturnsThe fund manager aims to beat the benchmark index to gain higher returns for the investors.The fund manager works with the index and aims to mirror the returns given by the index
Expense ratioThe expense ratio usually rests between 0.08 to 2.25% depending on equity or debt orientation. The lower the ratio, the better it is for the investor.The expense ratio is a maximum of 1%.

Causes for Passive Funds Gaining Traction?

There is growing evidence that it is harder for fund managers to beat the market over a long investment horizon and therefore, passive investments are a safer bet. Low cost in terms of lower expense ratio, is of great advantage in the long term due to compounding effect.

There are no unsystematic risks involved in a passive fund as the fund manager need not evaluate certain stocks in the market. The investor only needs to cope with the market risk and nothing additional. One can easily create long-term wealth just by investing in a market index and past performance of the index can be a testimony to that.

Investing in a passive fund is simpler and involves fewer decisions to be taken based on the past performance of the fund manager, the stock selection strategy, market conditions etc. The lackluster performance of active funds has also contributed to the increased investment in passive funds.

How are Passive Funds Gaining Trust?

The Association of Mutual Funds in India (AMFI) observed that index funds had gathered an AUM of Rs. 7,717 crores as of November 2019. Passive large-cap ETFs have returns of 11.53% in the previous year, outperforming even actively managed Large-cap funds. In 2020, nine out of the top fifteen large cap schemes are passive funds.

As of August 2020, assets managed by ETFs tracking the Nifty 50 Index crossed a milestone of Rs. 1,00,000 crores while the total AUM of passive funds amounted to Rs. 2,00,000 crores.

Is this a global phenomenon or is it localised?

This increased trust and investment in passive funds is a global phenomenon – a trend that has been observed for the past few years. Globally, the passive fund industry is a multi-trillion-dollar industry helping save investors a lot of money in terms of fees.

Over the past few years, passive funds such as Exchange Traded Funds, Index Funds, and the like have been increasing their presence in India. The pandemic saw a jump of about 49% in the assets under management (AUM) in index funds, gold ETFs and other ETFs in 2020. It is gaining traction in India due to the low expense ratio. 

Having said that, passive investments will not substitute or replace active funds. The two are going to co-exist and flourish alongside. 

The government of India is also providing a push by launching CPSE ETF for disinvestment. The government has also allowed the Employee Provident Fund Organisation to rechannelise a part of their incremental corpus through ETF.

Is this a short term trend or is it here to stay?

Passive funds are an asset allocation tool. There is no indication of a reversal of the trend for the foreseeable future and if anything, experts believe that this trend is meant to stay and is only going to grow bigger and better.

The higher levels of sophistication of passive investing in western countries are yet to find their true expression in India, but once it does, the selling proposition for passive investments will only be more attractive and lucrative.

FAQs

  1. What is a passive fund?
    A passive fund is a type of a mutual fund that tracks a market index to get maximum gains out of it. ETFs and Index funds are types of passive funds.
  1. Who should invest in passive funds?
    Anyone who does not want to evaluate mutual funds and take decisions based on their own knowledge can follow a passive strategy. 
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