Financial Planning

Investment Planning

Are Index Funds & ETFs Right For You? The Truth Behind The Hype.

By Ankit Agrawal on Jan 4, 2024

In simple terms, passive funds, or index funds, are a type of mutual fund or exchange-traded fund (ETF) designed to mimic the performance of a specific market index. Think of it like this: instead of trying to beat the market, passive funds aim to match its performance. It's a hands-off approach to investing that resonates with those who prefer a set-it-and-forget-it strategy.

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What are the Different Types of Passive Funds?

Entering the world of passive investing might sound a bit overwhelming, but let's break down the different types of passive funds in simpler terms:

1. Index Mutual Funds:

These are like baskets of stocks that mimic a specific market index, making it easy for you to invest in a bunch of companies without picking each one. Example: If you hear about the Nifty 50, an index mutual fund tracking it would include shares from those 50 big companies.

2. Exchange-Traded Funds (ETFs):

ETFs are like a mix between a stock and a mutual fund. You buy them on the stock market, and they represent a collection of stocks or bonds. Example: If you're keen on gold, there's a gold ETF that tracks the price of gold without you needing to buy physical gold.

3. Fund of Funds (FOFs):

FOFs are funds that invest in other funds instead of individual stocks. An FOF might invest in different ETFs or mutual funds, giving you broad exposure without the need to manage each one separately. They are also a great way to access international markets example:

- FOFs like Motilal Oswal NASDAQ 100 FoF: Tracks the performance of the NASDAQ 100 index, providing exposure to leading US technology companies.

- Reliance US Equity Opportunity FoF: Invests in a mix of US growth and value stocks across various sectors.

- ICICI Prudential Multi-Asset FOF: Offers a diversified portfolio across Indian and international equities, debt, and alternative assets.

Disclaimer: I'm not recommending or suggesting these funds. The only purpose is to give examples.

4. Smart Beta Funds:

These funds add a bit of strategy to passive investing. They follow a different set of rules than traditional index funds to get better returns potentially. These funds follow the underlying index when it comes to performance but they also make changes to their portfolios based on how the market moves.

Advantages of Passive Funds (over active mutual funds):

Cost-Effective: Passive funds generally have lower fees (expense ratios) compared to actively managed funds. Since they replicate a specific market index, they involve less research and effort by the portfolio manager leading to reduced costs.

Ease of Use: Passive funds are often considered more straightforward for investors, especially those who are new to investing. The "buy and hold" approach aligns with a long-term investment strategy, reducing the need for frequent monitoring and decision-making.

Lower Risk of Human Error: With less reliance on individual fund managers' decisions, passive funds are less susceptible to human error or emotional decision-making. This can contribute to a more disciplined and systematic investment approach.

Risks of Passive Funds (over active mutual funds):

Underperformance: Since the fund manager is obligated to replicate the portfolio of the market index, investors lose the possibility of earning higher returns than the market index.

Less Flexibility: If the overall market takes a dip, your passive fund will too because fund managers do not have the option of making changes to the portfolio’s allocation.

Tracking Error: This is the difference between your fund's performance and the index it's trying to copy.

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My Take On The Financial Potential Of Passive Funds in India

Hidden Gem Opportunities: Unlike the US, India offers a wider landscape of unexplored small and mid-cap companies with the potential for substantial growth. Active research and stock picking in these sectors can potentially lead to higher returns compared to passive index funds.

Low Liquidity Challenges: The smaller transaction volume in certain segments can create liquidity challenges for fund houses. Their larger trades can significantly impact market prices, limiting their ability to generate alpha (outperformance) and potentially hindering returns.

In conclusion, both active and passive investing have their advantages and disadvantages. Choosing the right approach depends on your individual risk tolerance, financial goals, and investment time horizon.

Passive funds like index funds or ETFs offer simplicity, and cost-effectiveness making them a compelling choice for conservative investors seeking a stress-free path to achieving financial success.

However, if you want higher returns be careful about choosing a passive fund. Actively managed funds aim to exceed market indices through strategic stock decisions. Index funds and ETFs lack this flexibility and limit returns. In market downturns, actively managed funds can adjust portfolios for less impact, offering additional advantages.

Unsure if passive fund investing is right for you? Chat with us to explore which funds suit your goals and risk profile.

Passive Fund FAQs:

Q: What is Passive Investing?

A: Passive investing means letting your money follow the market without trying to outsmart it. It's like taking a backseat and enjoying the ride as your investment mimics a specific group of stocks or bonds.

Q: Who should invest in passive funds like index funds or ETFs?

A: Passive funds, such as index funds or ETFs, are well-suited for conservative investors seeking a low-cost, diversified approach to the market. They are a good fit for those who prefer a hands-off investment strategy and prioritize simplicity. People who want more gains/returns in exchange for a slightly higher fee should invest in active funds.

Q: Why Does a Fund Follow Passive Investing?

A: Funds follow passive investing to keep things simple. Instead of paying someone to pick and choose stocks, they track a market index. It's cost-effective and straightforward for investors.

Q: Do Passive Funds Continuously Monitor Portfolios?

A: No, they don't need constant babysitting. Once a passive fund sets its course to match an index, it stays on that path. There's no need for continuous monitoring because the aim is to replicate the index's performance.

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