Choose passive investing to enhance wealth creation

There are some debates in the world of investing that go way back. Whether it is value vs growth or passive vs active, there are followers and detractors of both approaches. However, what you really need to think about is what works for you best and how you can leverage the advantages of different styles of investing.

Take for example Arun Sharma. Twenty years back when he started his financial planning journey the only two investment options that he knew about were bank fixed deposits and equities. One offered fixed but relatively low returns which often were not even able to beat inflation. On the other hand, equities offered the potential to generate strong returns over a period of time but came with higher risk. Due to these factors investors either ended up investing most of their investments in low yield and low risk fixed income investments or potentially high yield and high risk equities. Arun had a similar issue. He had only these two choices and ended up making sub-optimal investing decisions. However, today, when his 25 year old nephew, Sid, is starting his investing journey, he is spoilt for choice. He does not need to select from the two extreme ends of the spectrum, i.e., high risk and high return or low risk and low return. There is a mid-path, called passive investing, which can help him generate good returns without taking the commensurate risk or paying the high costs of active investing. As a matter of fact, Sid is not the only one who is actively considering investing the passive way. An increasing number of investors in India are now gravitating towards passive investing.

Let’s see what the numbers are telling us. The amount of money being invested in passive schemes has been increasing. Just over a year ago, in January 2020, the total amount of money invested in index funds and ETF was around INR 8,082 crore and INR 1,84,534 crore, respectively. However, in just over a year, as of May 2021, this amount increased to INR 22,904 crore and INR 3,16,289 crore,

registering a staggering growth of 183 percent and 71 percent, respectively. However, this is still a drop in the ocean compared to the fact that the overall money invested in mutual funds currently amounts to approximately INR 37,40,791 crore. This also points to the immense opportunity for passive investing to grow in India.[1] https://www.amfiindia.com/indian-mutual 

So, what exactly is passive investing and why is it so attractive?

Passive investing is a strategy that involves buying all the stocks or other securities in an index. Passive fund managers buy the securities in a benchmark index, in the same proportion as the index, and then simply hold the securities unless there is some rebalancing in the index. The main aim of a passive investment strategy is to generate returns that are similar to the returns generated by the index or the basket of securities. Unlike active fund managers who seek to outperform the market, passive fund managers seek to perform like the market. There are some very clear benefits of passive investing. These include:

• Low cost:Since the main aim of passive investing is to perform in line with the benchmark and not outperform the benchmark, fund managers don’t need to spend a lot of time and energy in research and stock selection. Hence, the fund manager fees are usually quite low. Further, due to its slow and steady approach and infrequent trading, transaction costs are low as well. As a result, the fees that you pay to passive fund managers is relatively low compared to active fund managers.
• Diversified holdings:Since passive investing generally involves investing in benchmark indices, portfolios created through such a route are often well-diversified. Generally, if you want to achieve diversification then you need to buy multiple securities belonging to different sectors. However, if you follow passive investing then you can achieve portfolio diversification just through a single investment in a fairly efficient and low cost way.
• Less risk:It is well-known that a great way to reduce portfolio risk is through diversification. Thus, passive funds can help you achieve diversification as well as reduce portfolio risk. Further, investors can choose to optimise the diversification benefits of passive investing by investing a range of passive funds across diverse asset classes like debt and equity, themes, and sectors.

How can Arun, Sid, and many investors like them take advantage of passive investing?

An individual equity investor can create a passively managed portfolio by simply buying all the index stocks in the same proportion as the index and then holding them for a long period of time. By doing this, the investor will be able to replicate index returns. However, this can become challenging since the individual investor will need to track index changes in terms of composition, weight, and corporate action and ensure that these changes are reflected in his portfolio. This can be a complicated and tedious process.

Thus, a simpler way to follow the passive investing strategy is to directly buy an index fund. These are mutual fund schemes that buy all the stocks or components of a specified benchmark index in the same proportion as the index. The fund manager ensures that the performance of the scheme replicates the performance of the index. These can be easily purchased directly from the Asset Management Company (AMC), distributors, or through online platforms. The biggest advantage of index funds is that the cost of such funds is very low. This is because, unlike an active fund manager, the passive fund manager does not need to do a lot of in-depth research and select the best securities for the portfolio. The good part is that today you can choose to invest passively in multiple asset classes including debt, equity, and gold.

The bottom line is that today investors don’t need to compromise when making investing decisions. They have a wide range of choice and can easily choose the products that best suit their risk returns requirements. While all investment decisions should ideally be taken from the perspective of the individual’s risk-return requirements and investment time horizon, every investor can consider allocating a small part of his / her portfolio to select passive funds. 

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