With the shift towards passive funds, many mutual fund houses are launching several passive mutual funds. They require no management costs or frequent portfolio churns and are often less expensive than active investments. As a result, long-term investors can use passive investments to build wealth.
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What are Passive Mutual Funds?
A passive fund is a mutual fund that constructs its portfolio by tracking a market index or a specific market segment. Unlike active funds, the fund manager doesn’t do any research to identify the stocks to be part of the fund portfolio. As a result, passive funds are a low-cost investment option.
The fund manager simply mimics the index composition. The main aim is to replicate the benchmark portfolio with a minimum tracking error. Thus, the returns are close to the market returns.
For example, a fund tracking the Nifty index will have the same 50 stocks in its portfolio. Similarly, if a fund is mimicking the BSE Sensex, the fund’s portfolio will include the same 30 stocks that are part of the BSE Sensex. Furthermore, the stock weights are similar to that of the index holdings.
Following are the two types of passive mutual funds:
Index funds mimic the underlying benchmark index. The focus can be market cap, sector, theme or a broad market index. The job of the fund management team is to replicate and maintain the underlying benchmark’s composition.
These funds’ returns are almost the same as the benchmark. However, there will be a slight difference in performance. The variance is due to a tracking error. Therefore, the fund with the slightest tracking error is the best pick. Furthermore, all future inflows are invested in the same proportion of the underlying index.
Exchange Traded Funds (ETFs)
Exchange-traded funds (ETFs) are a type of passive funds that track the performance of an underlying index. An ETF is a portfolio that closely resembles an Index. ETFs don’t try to outperform their benchmark indexes.
Furthermore, ETFs trade on the stock exchange, and thus one can buy and sell ETFs on the exchange. As a result, the ETF prices fluctuate throughout the day. The net asset value of the underlying stocks in the portfolio determines its value.
Things to Know About Passive Mutual Funds
Following are the things to know about passive mutual funds:
The investment strategy of passive mutual funds is to buy and hold. Since they mimic the composition of the benchmark index, the fund manager doesn’t spend much time rebalancing the portfolio. Thus, passive mutual funds are low-cost investment options compared to active mutual funds. In addition, passive funds employ various investment strategies, such as tracking a sector index, broad market index, etc.
Passive mutual funds aim to replicate the benchmark index like the Nifty or Sensex closely. In other words, the portfolio composition and stock representation of the passive mutual fund and the underlying benchmark will be more or less similar. Since the compositions are identical, returns from passive funds are close to the market returns. However, passive funds do not aim to outperform the index, unlike active funds. Instead, the passive fund’s objective is to earn benchmark returns as closely as possible. However, the risk is lower in comparison to active funds. Furthermore, the gains are compounded over time as passive fund investments are suitable for long term objectives.
Passive mutual funds are market-linked instruments and thus are risky. However, compared to actively managed funds, the risk levels are much lower. Moreover, since passive funds replicate the benchmark index, their portfolio is well-diversified, and you can earn benchmark returns if your investment horizon is long-term.
Passive funds do not require constant portfolio monitoring since their portfolio composition replicates the underlying benchmark. Thus, panic selling and buying don’t occur when the market fluctuates. In addition, these funds are more diversified than active funds and are not biased towards any stock or industry.
Passive funds are low-cost investment schemes since they do not involve the active buying and selling of securities. Furthermore, as they replicate the benchmark index, the portfolio revisions are not often. Thus, the fund manager doesn’t have to track the portfolio regularly. As a result, all the associated costs are much lower when compared to managing an active mutual fund. Hence, passive funds are popular low-cost schemes.
With the gaining importance of passive investing, the opportunities look bright for passive mutual funds. However, active investing has its drawbacks of being unable to generate benchmark beating returns and high volatility. On the contrary, passive mutual funds more or less deliver benchmark returns. Furthermore, since these schemes replicate the benchmark index, the fund manager’s risk is also low. In other words, the fund manager doesn’t pick the stocks to invest in. As a result, the fund manager’s decisions do not impact the fund’s returns. Thus, passive funds are a lucrative option if you seek to earn benchmark returns in the long term and do not like actively managed funds.