Passive Investing: Benefits and Strategies To Maximise Returns
Passive investing involves buying and holding assets for a longer period. Unlike active investing, there is less frequent buying and selling in the passive investment style. There are various types of passive investing, including investing in real estate or investing in dividend-paying stocks.
A popular type of passive investing is investing in index funds. These funds do not require active fund management as they mimic stock market indices such as NIFTY50. These funds buy and sell stocks only when stocks enter or exit the indices tracked by the fund.
Features and Benefits of Passive Investing
Here are some of the primary features of passive investment funds:
- Mirrors the returns of an Index: Passive investing doesn’t require individual stock selection. The idea is to replicate the composition of an index and expect returns based on market performance.
- Buy and Hold strategy: The fund managers of passive mutual funds try to match the index performance, which doesn’t require frequent trading. It is more suitable for investors who are looking for long-term capital gains.
- Easy to understand: Passive investments are simple to understand and easy to execute. The goal of the passive mutual fund is to replicate an index which doesn’t leave much room for portfolio modifications.
- Allows diversification: The mirroring strategy of passive mutual funds automatically diversifies its investment portfolio. Passive funds focus on the top companies listed on an index, which are spread across various sectors and industries.
- Low expenses over time: The transaction costs in passive mutual funds are lower since there is no frequent trading. Passive investments also do not require constant monitoring by experienced fund managers. This reduces the role of fund managers, which in turn reduces the expense ratio.
Strategies for Passive Investing
Passive investing is a style of investment that uses the buy-and-hold portfolio strategy to maximise its returns. The goal is to never sell your holdings, even if the market fluctuates dramatically. Your portfolio should replicate the financial index performance to maximise its returns.
One of the most common passive investing strategies is to invest in an index fund. These are passively-managed funds that replicate the performance of an underlying benchmark index, such as NIFTY50 or NIFTY100. The fund managers attempt to match the returns of the index by adjusting the holdings of a passive fund. Index funds offer simplicity, and investors can benefit as the market increases over time.
Passive Investing – History
Passive investing originated in the United States in the 1970s. In the 1950s, in post-WW2 America, all funds were active. Between the 1950s and 1970s, academics such as Burton Malkiel started publishing research in favour of diversified portfolios. In his famous book, “A Random Walk Down Wall Street,” Malkiel argues that a diversified portfolio is better for investors than buying individual stocks or investing in actively managed portfolios.
Legendary investor Jack Bogle got inspired by these academic findings and the 1973 market crash. So in 1976, Jack’s firm, The Vanguard Group, launched the world’s first passive index fund – the Vanguard 500 Index Fund.
Since then, passive investment has grown in the US in a big way and today, more assets are invested in passive funds than active funds.
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Difference Between Active and Passive Investing in Mutual Funds
Passive investing involves investing in passively managed funds. On the other hand, active investing refers to investing in actively managed funds with frequent buying and selling. In actively managed funds, fund managers actively try to maximise the gains by buying potential winners and minimise the losses by selling potential losers. While active funds are constantly trying to outperform the benchmark, they may not always be successful in their objective.
Here are some recent statistics on active vs. passive funds from India. According to data from SPIVA (S&P Indices versus Active), as of June 2020, 80.43% of active funds underperformed the BSE 100 index. On a one-year basis, 48.39% of the funds underperformed the BSE 100 index. These statistics show that 80% of funds could not match market returns, let alone beat them. In contrast, by their very nature, passive funds are designed to match the returns of the indices they are mimicking.
Active vs Passive Investing – Which One to Choose?
Active investors have a completely different view on building wealth than passive investors.
- The goal of active investing is to seek profit from short-term market fluctuations. The fund managers of active mutual funds engage in “market timing” and try to outperform the market. They are constantly evaluating, modifying and trading the portfolio’s assets.
Although this attracts a high expense ratio, investors can be assured that the fund is being managed by a seasoned fund manager. - On the other hand, passive investors believe in the market’s ability to provide lucrative returns over time. The fund managers try to replicate the performance of the top companies in an index instead of out-thinking the market.
There is a lack of flexibility in the portfolio’s management; however, passive funds have extremely low expense ratios.
Whether you select an actively-managed fund or go with passive investing depends on your market understanding. Passive investing is cost-efficient and less complex, making it ideal for new investors. On the other hand, active investing offers flexibility which can be suitable for experienced investors.
Limitations of Passive Investing
While passive funds have many benefits, they also have a few limitations:
1. Not Possible to Outperform the Benchmark
Passive funds mimic the market, so there is no scope for the fund to outperform the benchmark. In contrast, actively managed funds are constantly buying and selling stocks to try and stay ahead of the benchmark. In addition, active funds can react to market changes and reshuffle their portfolio to maximise gains where passive funds do not have such flexibility.
2. Greater Downside if Market Falls
If the market falls by, say 5%, passive funds will experience a similar loss. Fund managers cannot take any action to minimise the losses. In comparison, fund managers can act swiftly in response to a falling market in active funds and mitigate their losses. They can also take advantage of falling prices to make new investments at low prices.
Factors to Consider Before Selecting Passive Investment
Here are a few factors to consider before selecting passive investing instruments:
- Investment goal: Investors must carefully consider whether they want to allocate their passive funds in broad indices like NIFTY 100 or other kinds of sector-oriented funds like infrastructure, banking, etc. Selecting the right passive fund should depend on the investor’s risk appetite.
- Expense ratio: Passively managed funds are popular among investors because of their cost-efficiency. However, investors must avoid selecting an index fund for passive investing just because it’s cheaper. One must assess the fund’s past performance to evaluate the potential returns.
- Tracking error: Tracking error is the difference between the index returns and the returns of the passive index fund. It’s nearly impossible to match the exact benchmark performance of an index; however, it is advisable to select index funds that have lower tracking errors.
Final Word
Passive investing is ideal for investors looking to match the returns offered by the benchmark and not outperform the benchmark. On the other hand, active investing is more suited for investors willing to take risks to get higher returns than the benchmark. Sometimes these risks pay off, and sometimes they do not. To get started, visit Navi Mutual Fund now!
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
