Invest in passive mutual funds for the right reasons (2024)

There are many things in life that are effortlessly simple and yet we tend to complicate them. The narrative around passive investing and passive funds seems to have fallen into that trap. The two most important things for an investor are returns and safety of capital. At the same time, it is commonly believed, and is partially true, that to generate higher returns one might need to take higher risk. Thus, when we talk about passive funds, we tend to focus on falling alpha and limit the conversation to comparison with active funds. However, passive funds are much more than that and can add value to investor portfolios in several ways.

Passive investing is the simplest form of investing. It may also be called rule-based investing where there is no human intervention. Most passive funds in India are based on broad market indices which simply put together a bunch of companies based on their market cap size and then weight them using free float market capitalisation.

While passive investing should be known for its simplicity, we are guilty of making the narrative a bit complex. As an investor, the first thing that you ask about an investment option is its potential to generate returns. Now, this is a fairly simple question which deserves a simple answer. Something along the lines of X% should suffice. However, what you hear instead is that, ‘active funds may not generate alpha’ or ‘it will beat actively managed funds’. Unfortunately, this does not answer your question and leaves you more confused than before.

Correspondingly, another word that has become synonymous with passive investing is ‘low-cost’. While costs are important, a few basis points should not be the only criteria for selecting a fund. Also, costs are not constant and may change. For example, in recent years, costs of passive funds have inched up a bit while that of active funds have come down. Some direct options of active funds are available at an expense that is equal to or lower than some passive funds. When we talk about alpha and low cost as the only benefit of passive investing, we restrict our communication to people who understand that language and are probably already investing in equities. This leaves out large swathes of potential investors who are just looking for simple investment solutions that can generate returns better than traditional investments like fixed-deposits, gold, and real estate.

Passive funds solve the basic problems of both new and seasoned investors. They are simple and can be used for effective portfolio diversification. They are like dal-chawal which is simple and loved by almost everybody. On the other hand, there might be some people who also love biryani, which is equally good and has its own appeal. We love dal-chawal for its simplicity and taste, not because it is light on our wallet.

Passive funds for new investors
Choosing the right investment fund for your portfolio can be a tedious and challenging task for new investors, especially if you do not have an expert by your side. You need to first understand your portfolio requirements and then look for the right fund by studying fund style, performance across cycles, risks, etc., and continue to review and track the fund consistently. This is a difficult task for new investors.

For such investors, passive funds like index funds are a simpler choice. Index funds are simple, easy to choose and track, available at a low-cost, and offer market linked returns. Yes, index funds might be doing better than some active funds, but there are some active funds too which are doing better than index funds. Thus, alpha is not the only reason to invest in index funds. Passive funds can also be a great option for all those investors who prefer to adopt a Do-it-Yourself (DIY) approach to investing.

Passive funds for seasoned investors
Investors who already have a portfolio of active funds can add passive funds to complement their portfolios and potentially enhance risk-adjusted returns. The addition of passive funds to the portfolio may reduce some risks of underperformance that may come through in an active fund in the short- term due to different investing styles.

Equally important are the diversification benefits of passive funds that can accrue to both new as well as seasoned investors. When you invest in an index fund, you get exposure to all the constituents of an index through a single investment. For new investors, this is a great way to enjoy the benefits of diversification while for seasoned investors, this is a great way to complement their existing portfolios.

There is great potential for passives in India provided it is packaged in the right box that is suitable for investors. I think the phase where people will invest in passive for its simplicity lies ahead of a phase where they will invest because active is not generating alpha. Either way, passive funds are multi-faceted in nature and are likely to gain further momentum in India.

(The author is the Head-Products, Marketing & Digital Business, Edelweiss AMC.)