At a time when the stock market is making record gains, many new investors are considering entering the market. In addition, existing investors are looking to increase their stakes. However, people often get confused in choosing between active or passive investing styles to meet their financial goals. In this article, we will address all questions related to passive investing.
First up, as the name suggests, 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.
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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.
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.
Broadly, there are three benefits of passive investing:
Low Expense Ratios
Expense ratios determine how much of the returns fund houses pass on to the investors after deducting the fund’s administrative charges. Lower expense ratios are better for investors. Passive investors have lower fund management fees as managers are not actively buying and selling stocks, resulting in low expense ratios.
Easy Availability of Information
Actively managed funds share the breakup of their portfolio either monthly or quarterly or semi-annually. At other times, investors are not aware of the buying and selling happening within the portfolio. Also, a fund manager doesn’t need to explain why a specific stock was chosen.
On the other hand, passive funds mimic an index like the NIFTY 50. Therefore, if you invest in a passive fund mimicking NIFTY50, you will know at any point how your portfolio looks.
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While passive funds have many benefits, they also have a few limitations:
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.
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.
In conclusion, 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.
Before you go…
Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully before investing.