Why mutual fund investors should understand passive investing…

If you are a mutual fund investor you are sure to have seen advertisements of mutual fund advertising their performance. These are typically referred to as active funds. These active funds have managers who indulge in stock selection and try to outperform the Nifty or the Sensex. For example over the last 1 year if the Nifty has earned 14% and the fund manager has earned 19%, then the fund manager is said to have outperformed the index. Passive investing, on the other hand, is just investing in the index. How do you do it? You can do it by simply buying an index fund.

But the question that arises is; when there are fund managers who can outperform the index, then why should we buy index funds. An index fund, as the name suggests, is buying the index. The manager just buys all the stocks in an index in the same proportion as the index itself. So if there is a Nifty Fund, then the manager just buys all the stocks in the Nifty in the same proportion. There are quite a few reasons for an individual to buy index funds in their portfolios.

Index funds are low cost products…

Index funds do not require active management. Hence the cost of operating an index fund is much lower. AMCs are able to pass on this lower cost to the end users and hence you will find that the average cost of an index fund is substantially lower than a normal actively managed mutual fund. Over a period of time, this cost saving really adds up.

Returns are quite attractive in index funds…

Most index funds do generate attractive returns over a longer period of time. Take the example of the Nifty. Over the past 22 years, it has appreciated almost 80-fold. In terms of compounded annual growth rate (CAGR), the annualized return over the last 22 years would have been around 23%. That is a fantastic return, especially when you do not even have to worry about tracking your mutual fund performance.

Passive funds give you a wide choice…

Broadly, passive funds come in two varieties for investors. They are in the form of an index fund where a portfolio of similar stocks is created in the same proportion so that tracking error is reduced to the bare minimum. Secondly, there are ETFs or Exchange Traded Funds where any asset class like an index or even gold can be used as an underlying and the return can be linked to the price of the same. In fact, gold ETFs are quite popular in India and represent a very economical and simple way of participating in gold price movements.

They reduce the risk in your portfolios…

Passive funds like index funds give you an in-build diversification. An index is, by default, diversified with a wide variety of stocks from different sectors. This provides the index fund with an in-built diversification and reduces the overall risk that an investor is exposed to.

The moral of the story is that investors do not need to go overly aggressive on index funds. But it must make a small part of their overall mutual fund portfolio. It is a low-cost product that offers you diversification and attractive returns over a longer period of time.

For all your mutual fund queries SMS ‘ASKMF‘ to 575758 and we will get back to you.

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