The truth about equity investing in India is that it’s uncommon & a very small number of people invest in it (3.7% invest in equities, compared with about 12.7% in China as of March 2021). 9 months back, this number was only 1.5% (in June 2020). This data tells us that majority of the investors in India are new & since they have no experience in equities, their decisions will most probably be majorly influenced by social media/word of mouth by friends & family, etc.
It’s natural for human psychology to get attracted to things that are more complex and tend to completely ignore things that are simple and potentially more effective for the purpose/cause. But in most cases, that is not always the truth. As told by Steve Jobs himself:
“Simple can be harder than complex.
You have to work hard to get your thinking clean to make it simple.
But it is worth it in the end, because once you get there, you can move mountains.
One thing that always worked for Steve Jobs, one of the most influential person of our times, was that he made sure every product launched by Apple was very simple & intuitive to use for the end customer. For the majority of people, simple products just work.
Given an option between driving a manual & an automatic car, which will you choose? For the majority of individuals, the answer is an automatic car. Sure, car enthusiasts who like manual intervention while driving will prefer a manual one but the majority will not care for it. The idea is to get from point A to B in the simplest way possible.
Such is the exact ideology of passive investing. A simple & easy to understand product suitable for the majority of investors. In India, passive investing might be a relatively new concept, but in the developed western markets like the USA, passive investing has already crossed >50% in AUM of the total mutual fund industry.
But what is passive investing?
In simple words, there are two types of investment strategies in the mutual fund business. Active & Passive Investing. In active investing, there is a fund manager who actively selects stocks based on his team’s research & sets a benchmark index (like Nifty 50, Nifty Next 50, etc.) to compare performance. The manager aims to outperform the said benchmark (which acts as a yardstick) over a given period.
Studies have suggested that consistent outperformance is difficult (but not entirely impossible) & that’s where passive funds came in. Passive funds follow a strategy where they chose a broad-based index & try to replicate its performance by buying all stocks with the same weight as in the index.
To give a brief overview about passive funds, they are of two types i.e. Index funds & Exchange-Traded Funds (ETF’s). Index Funds are just like normal mutual funds with the exception that they only replicate the index. ETF’s however combine the benefit of both stocks and mutual funds. They are mutual funds that get listed on the stock exchange and can be actively traded like stocks during market hours.
To further understand why passive funds are simple and what makes them good enough for the majority of us, we take a look at the following reasons:
Generally, passive funds have an expense ratio in the range of 0.05-0.5%. Compare that to its counterpart that has an expense ratio anywhere between 1-2.5%. A simple 1.8% difference in expense ratios compounded over 10/20/30 years can make a huge difference of as much as 50% more in the overall corpus .
The whole idea of passive funds is to simply replicate the index and buy each stock in the same weight as that of the underlying index. A stock market index tracks the price of a group of companies to get a general idea of the broader economy/sector/theme/industry 3. The aim is to make returns that are very similar/close to the index return.
Are they better in terms of returns?
S&P Dow Jones Indices provide a semi-annual study that compares the performance of active funds to their benchmark indices. In its Dec-2020 report , it found that >80% of the funds in the Equity Large-Cap category could not outperform their respective benchmark indices over a 1/3/5 year period on an absolute basis. This means 4 out of 5 funds failed to outperform the benchmark.
As discussed earlier, Index funds & ETF’s are two types of passive funds. Index funds, being like any other mutual funds, are generally available to purchase/redeem at any time. Just like stocks, ETF’s are listed on stock exchanges & can be traded throughout the day. This gives investors the freedom to take advantage of transacting in ETF’s during market hours & buy it at real time prices.
Reduces risks & biases
Passive investing is simply replicating an Index. Just like in an automatic car where changing gears is dependent on the car’s automatic mechanism, the fund manager doesn’t play any role in selecting stocks for inclusion/exclusion & is simply replicating underlying index. Thus, it eliminates any kind of biases in terms of style, stock or sector.
Turnover is the proportion of stocks that have been replaced in a portfolio and is experienced by every mutual fund. Most of the indices typically experience very low turnover which leads to low turnover for passive funds. This directly helps in saving the cost of trading.
Key Personnel risk
In an active mutual fund, the performance of the fund is highly dependent on the ability of the fund manager which exposes it to key personnel risk. The fund may or may not perform in the same way after the departure of the fund manager & poses a big risk for its investors. This problem is eliminated in passive funds since it doesn’t require active stock picking or market timing.
All the reasons mentioned above make passive funds a very good investment product for experienced investors and an attractive entry point for investors who are new to equity investing. So, to wrap it up, passive products are very cost-effective, inherently simple in nature and carry comparatively less risk & biases.
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