Should Passive Funds Feature More in Your Portfolio?
Last Modified on
Investing in mutual funds has never been as popular as it is today. With the introduction of Systematic Investment Plans or SIPs, the ease of investment has been magnified, allowing even small investors to become a part of this educated gamble. Traditionally, investing in active stocks and funds was a preferred choice, but investing in passive mutual funds is now becoming the norm.
Here are some insights into passive funds and why they should acquire a greater proportion in your investment portfolio:
What are passive funds?
Passive funds are tracker funds that predominantly focus on generating similar returns as their benchmark or the target market. The idea here is not to outperform the benchmark like active funds but to keep in line with them. In the case of passive funds, the fund manager does not need to stock pick the investments but is required to replicate the target market or market segment.
Since there is no active involvement of the fund manager, passive funds are comparatively lower in cost than active ones. Generally, investors get confused over which fund type to choose, as both options are fundamentally different investments. But with growing engagement and limited market knowledge, investors are flocking towards passive investments more than before.
There are two types of passive funds you can look forward to investing in:
- Index funds: The funds that track any market index or indices are called index funds. S&P 500, FTSE 100, etc are some examples of indices. The index fund essentially mimics the investment portfolio of the benchmark index to generate similar returns.
- ETFs: Exchange-traded funds are funds that replicate indices like SPDR S&P 500 ETF, allowing investors to trade passive funds just like stocks on different stock exchanges. ETFs are more tax-efficient. Their trading also takes place over like-kind exchanges.
Here are some benefits of having a portfolio that is inclined towards passive funds:
The biggest advantage of investing in passive funds is that they are highly cost-efficient. Investors can save a considerable amount of money in expense ratio, which is the management fee charged by fund managers. The expense ratio can go up to 2% of the total portfolio value which may initially seem to be a small number but ends up taking out a considerable amount from your earnings around maturity.
Since there is no constraint to actively time the market and make alterations in the portfolio, passive mutual funds are easier to manage. Passive funds simply replicate the investments that their benchmark fund makes and tracks it till maturity. Generally, the returns on passive funds are similar to their benchmarks and are good in numbers.
Passive mutual funds, especially ETFs, can be easily traded and revoked as required. This brings high liquidity in the system, allowing investors to enjoy the flexibility of sale and purchase in passive investing. Since these mutual funds are highly accessible and can be tracked for their pricing throughout the day, the transparency levels are also very high.
Passive mutual funds are slowly gaining recognition with each passing day. Conventionally, active mutual funds were considered to be a better investment option. But in the recent past, the returns generated by passive funds have been equally competitive. Investors are also more inclined towards them now as there is not a lot of difference in the return generated by active and passive funds. You can earn similar returns without having to pay an extra expense ratio for active funds.
No need to time the market
Since passive funds involve setting and replicating the benchmark at the time of purchase, the investors do not need to time the market frequently as in the case of active mutual funds.
Passive funds are highly suitable for investors who have a low or tight risk appetite. Conservative investors who do not want to expose their money to unnecessary risk can certainly opt for investing in passive funds. Active mutual funds come at an increased risk due to the active sale and purchase of stocks and funds. On the other hand, in passive mutual funds, the portfolios are stable and less dynamic.
Dollar-cost averaging is the mathematical formula that accounts for balancing out the spikes in the purchase price of your portfolio trends. When you invest in index funds, you simply buy them without having to revisit them from time to time. The benchmark keeps doing its work and generates returns over the investment horizon. On the same grounds, the passive mutual fund or the index fund replicates the investment trends of the benchmark fund.
There may be times when you buy a greater number of funds at a lower price. On the other hand, at times, you may also end up buying fewer funds at a higher cost. However, the overall average returns would be nearly similar. This is called dollar-cost averaging. The time frame typically must be around 20 to 25 years for realizing such returns.
To sum it up
With these and many more benefits, passive funds have overtaken the interest of many investors. Their returns are similar to active mutual funds and offer advantages such as low cost, tax efficiency, and a maintenance-free nature. Passive mutual funds are a major attraction for investors who are not comfortable in timing the market. They are also good for people who do not have enough spare time to follow every fluctuation of the market. Moreover, since the returns are similar for both, investors are refraining from paying the additional expense to the fund manager for managing their assets.
Mutual fund decisions hold a lasting effect on your portfolio, which is why they need to be dealt with carefully. If you are looking forward to investing in passive funds, you can reach out to financial advisors for professional advice.