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Clearing top 6 myths around passive investing

Passive investing is an investing strategy that works well because of its cost advantage and simplicity

October 21, 2021 / 12:05 PM IST

Passive investing has gained a lot of momentum both in terms of the number of schemes on offer and the number of individuals opting for such schemes. Passive schemes command an AUM of Rs 3,10,330 crore with over 160 passive schemes on offer for investing.

For the uninitiated, passive investing is just a different way of investing. The premise of passive investing is that markets run efficiently and that it is difficult to generate returns over and above the market returns consistently. Two of the most commonly used instruments are index funds and exchange-traded funds. These instruments look at just mirroring the stocks in the index and do not actively pick stocks as per the views of a fund manager.

As more and more people are looking to adopt passive investing as their chosen method of investing, there remain some myths and misconceptions about passive investing. Let’s look at clearing some myths so that you can make an informed decision while investing.

Myth 1: Passive investing is only for beginners

Undoubtedly, passive funds like index funds or ETFs are very simple to follow and understand for an investor. The portfolio of the index fund/ETF remains the same as that of the index being tracked, which makes it easier to keep track of. So, an index fund often bodes well as a starting point for long-term investment to a beginner investor. But the same advantages hold good for any other investor as well who doesn’t want to spend time and effort in fund selection and monitoring.

Myth 2: Passive investing generates lower returns

Passively managed funds match market returns and actively managed funds look to outperform the market returns. But this doesn’t mean that passive instruments generate lower returns but look to generate returns in line with the index.

Over 1-, 3-, 5 & 10- year periods, a majority of the actively managed funds could not meet their benchmark returns according to a scorecard by S&P Global.

Myth 3: There are limited options for investing in Passive Investing

The most often heard passive investing options are those backed by the Sensex or the Nifty 50, but as it was pointed out earlier, there are over 160 schemes based on passive investing themes. So, you can choose passive products to replicate a mid-cap or a small-cap fund, a particular thematic fund like healthcare, banking, information technology, consumption, ESG, etc.

You could also choose to invest in gold, international indices, or debt through passive products like ETFs/ Index funds. Advanced passive instruments like Fund of Funds and smart-beta funds can offer further diversification.

So, there are a lot of products on offer through passive investing. You would have to choose the one or many that suit your asset allocation.

Myth 4: Passive investing suits only bear market phases

Active investing looks to generate alpha or returns over and above the market return through active stock picking. When the stock market is in a bull run, everyone looks towards active investing to generate extra returns while brushing aside passive investing. But the beauty of long-term buy and hold strategy, like passive investing, is in its ability to tide over effectively through phases of ups and downs and yet produce decent returns for the investors.

Myth 5: Passive investing is a risk-free option for investing

We know that passive investing does not involve active stock picking and just mirrors the index. So there are lesser expenses involved in fund management, resulting in a lower expense ratio. But just because there isn’t active fund management involved with a passive instrument, it doesn’t mean there is no risk involved in passive investing.

Equity markets are subject to systematic risks. They could be the cyclicality of the economy, political or geographical risks, currency risks(when investing abroad), interest rate risk, etc. These risks affect the market and are managed through effective asset allocation and diversification.

Myth 6: Passive investing produces exact returns as the index

In theory, passive investing instruments produce exact returns as the index. But there may be instances where a particular passive fund cannot meet index returns because of various issues like an index fund’s need to hold cash for redemptions, mutual fund expenses, or inability to buy a stock at the same price as the index.

Because of these factors, the performance of passive funds may not match that of its index. This deviation is known as tracking error, which is one of the metrics to be considered while picking a passive fund.

Passive investing is an investing strategy that works well because of its cost advantage and simplicity. But one should remember and practice the basics of investing at all times be it - paying attention to your risk profile, asset allocation, or maintaining diversification irrespective of the way one invests.

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first published: Oct 20, 2021 05:56 pm
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