Investment word of the day: Passive funds — a low-risk option for investors; how do they work?

Investment word of the day: The volatility and risk in the equities market are known to all, which often prevents people from investing in stocks. However, there is a way to invest in the equities market without the stress of selecting individual stocks and depending on market gains or losses. This simpler way of investing in the equities market can be done through passive funds.

What are passive funds?

Passive funds mimic the performance of a specific market index. It is appropriate for investors looking for cost-effective and less risky exposure to the market. As the name suggests, passive funds are passively managed and designed to mirror the performance of a market index such as the S&P BSE 500 or Nifty 50.

How do passive funds work?

Passive investing involves selecting a market index and creating a similar portfolio by investing in the same stocks in proportion to the index. The fund tracks the selected index and adjusts its portfolio as needed to stay in line with the composition of the index. There is no specific process for selecting stocks, as it entirely depends on the index. Hence, the role of the fund manager is limited in the case of passive funds.

How are passive funds different from active funds?

Investing in active funds involves a direct approach where the fund manager actively buys and sells stocks after analysing the market. Investing in passive funds comparatively requires minimal involvement from the fund manager, as the goal is to mirror the performance of an index by investing in the same stocks and proportions as the benchmark.

What should you consider when investing in passive funds?

There are several important aspects to consider when successfully investing in passive funds.

Investment objectives

You must first consider your investment objectives before opting for passive funds aligned with a specific index.

“For the underlying index, it is important to check whether it meets the expectations of the investment’s objectives whether they are wide-ranging with broad bases such as Nifty 50 or S&P 500 or sector-specific,” according to Bharat Mundada, Director, Mundada Finserve Pvt Ltd. Additionally, the financial goals one seeks to achieve, risks willing to be taken, and market conditions dictate the best time to invest in passive funds.

Look for expense ratio

Investors must check the expense ratio that reflects the percentage of a fund's assets that is used to pay for operating costs.

“A key consideration is the expense ratio because costs have a tendency to net returns in the future which compound over time. Investors will also want to focus on the tracking error, which provides a fund’s portfolio manager with an indication of how well the fund manages to track the benchmark index. Tracking errors that are lower are better,” he added.

Liquidity

One of the factors investors must consider before investing in passive funds is liquidity.

“Liquidity is important because funds with higher trading volumes in relation to assets under management (AUM) are generally more stable and therefore better,” Mundada said.

Beneficial for long-term investment

Passive funds are beneficial for long-term investments as they are typically more tax-efficient than actively managed ones. Additionally, long-term investors can take advantage of the reduced costs and compounding nature of these funds, according to Mundada.

“Passive funds are particularly useful during market uncertainties wherein active funds attempt to be managed but end up relentlessly failing to beat the benchmarks. There are also new investors who can begin investing in passive funds without needing to select individual stocks simplifying the process of building a diversified portfolio,” he added.

Passive funds also help to actively manage investment portfolios for an overall balanced risk exposure as part of a diversification strategy. They are an excellent alternative for investors who need steady wealth accumulation without constant active portfolio management.

In conclusion, while passive funds don’t require constant monitoring, periodic tracking is important to keep a check on your financial goals. Combining active and passive strategies can help capture market trends and reduce costs.