Mutual funds are an exceptional market-linked investment opportunity available at present, offering adequate risk diversification and the potential for significant long-term returns. However, selecting the right mutual fund can take time and effort, considering the range of options available in the market.
To make the right investment decision, it is crucial to differentiate between the types of mutual fund schemes available. However, in recent years, many investors have begun showing interest in passive mutual funds as it has developed the potential to help anyone earn sufficient returns regardless of their expertise in the market. Let us discuss the meaning and importance of passive investing in detail.
What are passive mutual funds?
When it comes to an active mutual fund, a fund manager looks after various tasks such as researching and selecting shares, determining the proportion of investment in each stock or sector, monitoring fund performance, and periodic balancing. On the other hand, in the case of a passive mutual fund, the fund manager does not perform all of these functions. Instead, passive mutual funds track a market index or a specific market segment. The fund manager simply constructs the portfolio by mirroring the stock market indices, resulting in returns that closely replicate the market returns. A portfolio that is passively managed takes the approach of a buy-and-hold strategy.
For instance, a fund that tracks the Nifty index would have the same 50 stocks in its portfolio. Likewise, if a fund replicates the BSE Sensex, its portfolio would have the same 30 stocks included in the BSE Sensex.
The most popular passive investment options are Index funds and ETFs, and both essentially mirror the indexes. Let us go through them in detail.
Index funds
Index funds build their investment portfolios passively by using a market index as a benchmark. As a result, they are referred to as passively managed funds, following the index’s performance. Index funds invest in the same securities of the index in the same proportion. The performance of the index fund will depend on the performance of the chosen index. Unlike actively managed funds, index funds do not aim to surpass the market, as their objective is to replicate the index’s performance. Also, note that you do not require a Demat account to invest in index funds.
Exchange Traded Funds (ETFs)
ETFs, or Exchange-Traded Funds, are securities that are traded on stock exchanges in the same way as stocks, allowing investors to buy and sell them throughout the trading day. This means that the prices of ETFs can fluctuate throughout the day based on supply and demand. Unlike index funds, you will need to open a Demat account for trading in ETFs.
These passive funds pool their investments from multiple investors and use the capital to invest in a variety of instruments, including commodities, equities, and bonds while tracking an underlying index. The value of an ETF is determined by the net asset value of the underlying securities in its portfolio.
What are the advantages of investing in passive mutual funds?
Low expense ratio:
Passive mutual funds replicate the performance of a particular market index. These funds invest in the same securities that make up the underlying index in the same proportion and therefore generate returns that closely mirror the index.
In contrast, actively managed mutual funds aim to outperform the market by employing a team of analysts and fund managers who make investment decisions based on their research and expertise. These funds tend to have higher expenses than passive funds because of the additional costs associated with research and management.
Therefore, passive funds generally have lower fees as the index replication strategy requires less research and analysis. Additionally, passive funds tend to have lower turnover rates (the rate at which the fund buys and sells securities), contributing to reduced costs.
Diversification:
Diversification is a risk management strategy that involves investing in a wide range of assets rather than just one. By spreading investments across multiple sectors and asset classes, investors can reduce the impact of risk associated with a single asset.
Passive mutual funds provide diversification. This is because passive funds track indexes that include top-performing stocks from a wide range of sectors and industries, resulting in an effective risk-reduction strategy.
Moreover, passive mutual funds are a cost-effective way to achieve diversification. Instead of investing in multiple individual stocks, which can be time-consuming and expensive, investors can simply invest in a single passive mutual fund that tracks a specific index.
Low risk:
As one of the most notable features of passive mutual funds is that they mirror the indexes, their performance remains consistent. Passive funds do not try to outperform the market. Additionally, as they provide a diversified portfolio, the risk is subsequently lowered. This makes it a good investment option for people with a low-risk tolerance looking for a long-term wealth creation plan.
Long-term wealth creation:
Passive mutual funds, as mentioned earlier, follow an index such as Sensex or Nifty 50 and generally perform better than a collection of individual stocks over a prolonged period. Consistency in performance makes passive mutual funds an attractive investment option for conservative investors seeking a reliable, long-term, low-risk investment strategy.
Conclusion
Passive mutual funds need less monitoring in comparison to actively managed funds. So, if your investment objective is to have a low-cost, diversified, and consistent investment plan, then passive mutual funds might be worth looking out for.
Disclaimer: The views expressed in the blog are purely based on our research and personal opinion. Although we do not condone misinformation, we do not intend to be regarded as a source of advice or guarantee. Kindly consult an expert before making any decision based on the insights we have provided.
