- Date : 16/03/2023
- Read: 4 mins
If you need to know what is a passive fund and why passive investing is the new buzzword, we have all the details for you.
What is a passive fund, and why should you know about it?
Investors have recently turned to passive funds as an investment option. Passive investing seeks to track the performance of a specific market index, such as the Nifty 50, rather than actively selecting individual stocks or securities.
While active investing has long been a popular strategy, passive investing has gained traction due to its lower fees, diversification benefits, and potential for consistent long-term returns.
What is a Passive Fund versus an Active Fund?
Fund management in India can be divided into passive and active funds. These are the two primary categories of mutual funds. Passive funds are designed to track a particular stock market's index, such as the Nifty or Sensex, by investing in the same stocks proportionally as the index. Passive investing involves buying and holding the same stocks as the index, with no attempt to outperform it.
In contrast, active funds are managed by a fund manager who aims to outperform the index by selecting individual stocks. As a result, fund management fees are generally lower for passive funds than for active funds.
Different Types of Passive Funds
Some of the prominent types of passive funds are:
Index Funds are mutual funds that aim to match the performance of a specific index or sector by investing in it in the same proportions.
Exchange-Traded Funds (ETFs) are pooled investments that track benchmark indices or sectors and can be traded on stock exchanges. ETFs can cover a range of asset classes, such as stocks, bonds, commodities, and currencies and their value changes in real-time.
Smart Beta ETFs (extension of ETFs) use a combination of passive investing strategies and active selection criteria to choose individual securities based on factors like volatility, value, growth, and momentum. As a result, they go beyond replicating an index, unlike traditional ETFs.
Fund of Funds (FoF) are mutual funds that invest in other mutual funds instead of individual securities. They offer the diversification, although they may have slightly higher expense ratios than index funds.
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Advantages and Disadvantages of Passive Funds
Knowing the benefits of passive investing is crucial if you're considering this type of fund management. Passive funds have lower expense ratios thanks to lower churn and monitoring. They also eliminate human bias towards a specific stock or sector, aiming to replicate an index or sector proportionately. As a result, it is easier to check the performance of passive funds vis-a-vis the index or sector they are reproducing. They are also simpler to understand than active funds, making them ideal for novice investors to generate risk-adjusted returns.
While passive funds have advantages, they also come with limitations. For example, passive funds cannot outperform the market as they track the index or benchmark. In contrast, active fund managers can and often beat the benchmark index. In addition, they may reduce the weighting of specific sectors or shares during bearish phases to achieve better returns.
Performance of Large-caps, Mid-caps, and Small-caps
According to data obtained by ICRA Analytics from MFI360, large-cap funds have struggled to outperform their benchmark, with only 8% managing to do so on a point-to-point basis over the five years until December 31, 2022. Similarly, on a daily rolling-returns basis, just 10% of large-cap funds have beaten the benchmark. In contrast, mid-cap funds have fared better, with 43% outperforming the standard on a point-to-point basis and 38% doing so on a rolling return basis. Small-cap funds have performed exceptionally well, with 86% outperforming their benchmark on similar parameters. It indicates a significant variation in performance across different fund categories.
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Passive funds are preferable for the large-cap portion of one's portfolio, while actively managed funds are better for mid-cap, small-cap, or theme/sector-based components. In addition, active small-cap funds are likely to perform better in bullish markets, while passive large-cap funds are likely to perform better in bearish markets.
Disclaimer: This article is intended for general information purposes only and should not be construed as investment or legal advice. You should separately obtain independent advice when making decisions in these areas.