Passive Fund Management: Meaning, How It Works, Advantages and Disadvantages

Meaning of Passive Funds

Remember, in the active investing chapter, we had a rough idea about the passive investing style. Just to recollect, passive mutual funds aim to replicate a market index like the Nifty or Sensex. These funds invest in the securities of the selected market index in the same proportion as they are present in the index. Fund managers of passive funds do not conduct any research to actively pick up stocks that can be a part of a fund’s portfolio. They simply imitate the index composition. 

For example, a passively managed fund tracking the Nifty 50 index will invest in the stocks of 50 companies that make up the index in the same proportion. 

Therefore, compared to active funds, these funds charge lower fees as they do not need to conduct in-depth market research to select investments individually. With these funds, you can opt for a cost-efficient way to diversify your portfolio and get exposure to a broad spectrum of market segments. With the rising popularity of passive mutual funds in India, you can diversify your portfolio and get returns that match the market. 

History Of Passive Funds - Global Scenario

The soul of passive funds lies in indices; hence, the story of their emergence will only be complete by discussing the advent of indices first. Stock exchanges, which were officially functional since 1612, got their first index in July 1884. It is called the Dow Jones Transportation Index. This index comprised eleven transportation stocks, including nine railway companies. The index got its name from its publisher, Charles Dow.

With the success of the Dow Jones Transportation Index, many indices were launched over the years. Still, the idea of replicating them as an investment strategy only arrived a few decades ago.

The two World Wars soon hit the world, and investments and stock markets took a back seat in people's lives. When stability came back in the 1950s, the stock markets, especially the US, saw a boom, bringing back the interest of investors and academicians alike. This was when several theories related to stock markets and mutual funds emerged.

• In 1952, Harry Markowitz’s “Modern Portfolio Theory” introduced the idea of risk-adjusted returns. The Nobel Prize-winning theory explained how risk-averse investors can construct portfolios to maximise returns.
• In the 1960s, Eugene Fama’s Efficient Market Hypothesis (EMH) came into the picture. The theory argues that earning excess returns or outperforming the market isn’t possible in the long run.
• And finally, in 1972, Burton Malkiel published a book, "A Random Walk Down Wall Street". This book proposed that historical prices have no predictive power.

These three theories are said to have birthed the idea of low-fee index funds.

During the same time, the concept of active funds came under criticism. Speaking in the US Congress in 1967, economist and Nobel laureate Paul Samuelson famously said that it was usually more profitable to invest in a mutual fund company rather than in their funds. Thus, Samuelson was one of the first to advocate the idea of index funds.

Jack Bogle finally picked up the idea in 1976 when he launched an S&P 500 index fund. Bogle launched the fund through The Vanguard Group, which he had established in 1975.

The fund took time to gain acceptance, but the mutual fund industry changed forever once it did.

The advent of Passive Investing in India

Passive investing took little time to arrive in India. However, it has only started gaining traction in the last few years. IDBI Index INit’ 99 Fund, launched in 1999, was the first passive fund in India. UTI Nifty Index Fund came shortly after in March 2000. 

Gold Exchange Traded Funds [ETFs] accounted for most of the Assets Under Management [AUM] till 2013. However, the start of the CPSE ETF in 2014 and the Employee’s Provident Fund Organisation [EPFO] resolution to start investing in ETFs based on the S&P BSE Sensex Index and Nifty 50 starting in 2015 immensely helped in the acceptance of passive equity funds. Similarly, with the launch of the 1st Bharat Bond ETF in Dec-2019, Debt passive funds became quite popular.

Working of passive funds

Passive investing revolves around choosing a market index and forming its replica by investing in the same securities in proportion to the index. Once the portfolio is made, the fund starts tracking the index closely and making changes to the portfolio as per the underlying index changes to make the fund almost identical to the index.

When it comes to passive funds, there is no process related to selecting stocks, as the stocks of these funds are similar to those of their underlying indices. Therefore, fund managers play a limited and passive role, which is the ultimate meaning of passive funds.

What are the different types of passive funds

• Index Funds

An index fund is a passively managed mutual fund scheme replicating a specified market index. These funds can be bought/sold just like any other mutual fund scheme and work similarly.

In passive index funds, the weightage of all securities is similar to that of the underlying index. If a security weight in the underlying index changes, the fund manager also buys or sells its units to match the weightage of the index.

However, these funds do not always yield the same results as that of their underlying indices because of tracking errors. Tracking errors happen because it is difficult to hold the securities of indices in similar proportions. Nevertheless, these funds are appropriate for those investors who want exposure to the broader market without investing in stocks or mutual funds.

• Exchange Traded Fund (ETF)

is another passively managed scheme replicating a specified market index. But one should have a demat and a trading account to invest in an ETF.

Unlike a typical mutual fund scheme or an index fund where one can invest directly through the fund house, units of ETFs are traded on the stock exchange like equity shares, and their price varies based on the Net Asset Value [NAV]. However, ETFs generally have a lower cost (expense ratio) than index funds. In terms of daily liquidity, ETFs outperform mutual fund schemes.

• Fund of Funds (FOFs)

As discussed in the mutual fund classification module, a FOF is a type of mutual fund that does not invest directly in securities. Rather, FOFs invest in the units of other mutual funds. Unlike an index fund or an ETF, a FOF may not necessarily track an index. 

For example, Fund A ( an international FOF ) might invest in units of various international mutual funds.

However, in certain FOFs, the fund manager actively decides how much to invest in which mutual fund scheme. They may further change the allocation on an ongoing basis. In such cases, FOFs cannot be called passive funds.

• Smart Beta

These are new and less talked about funds, especially in India, but they are getting popular these days. These funds are also referred to as strategic-beta funds or factor-based. These funds use a non-traditional weighting method instead of the traditional weighting (usually, market cap weightage method) to create a unique portfolio of securities. These funds follow investing factors such as momentum, value, quality, low risk, volatility, etc., to select securities and create a unique portfolio. 

However, please note that, unlike passive funds, these funds are actively managed and thus aim to beat the market in terms of returns. 

For example, a value-based smart beta Fund may use metrics like P/E ratio, P/B ratio, dividend yield, price to sales, etc., to identify stocks with lower prices than their intrinsic value. 

Thus, these funds mix the benefits associated with passively managed funds with the selection of active investments based on specific criteria.

Fee structure of passive funds

A key reason behind the growing popularity of passive mutual funds is the costs related to actively managed funds, which are used to pay fees to fund managers.

On the other hand, by nature, passive mutual funds require less effort. They do not need to actively sell and purchase securities. Since they replicate the benchmark, the fund manager can track their portfolio sparingly. Therefore, these fund schemes have a lower total expense ratio than their actively managed peers.

Returns of passive funds

Passive funds intend to mimic benchmark indices closely. In other words, regarding stock representation and portfolio composition, there is little difference between passive mutual funds and their underlying benchmarks. Given that the compositions are almost similar, returns from these funds are nearly the market returns.

But unlike their active counterparts, passive funds do not intend to outperform their underlying indices. Instead, the main objective of these funds is to gain benchmark returns as nearly as possible. However, compared to active funds, passive mutual funds have lower risks. On the other hand, since passive investments are appropriate for long-term goals, their gains are compounded.

Advantages of investing in passive funds

• Low-cost

ETFs and index funds have a lower expense ratio than any active mutual fund scheme. The primary reason is that they don't have any significant role for the fund manager as the portfolio is simply replicated from the chosen market index.

However, in the case of a FOF, this may not be true, as the investor ends up bearing the cost of both the expense ratio of the FOF and the underlying fund, in which the FOF further invests.

• Reduced risk of fund manager going wrong 

Although fund managers of actively managed schemes try their best to make investment decisions which are likely to return more than the market index, sometimes they may go wrong. Let's say a company whose stock they have invested in goes bankrupt, and its stock price crashes. In such a case, the entire fund’s performance will suffer. In the case of passive funds, the manager’s discretion is not there; thus, there is a low risk of making wrong decisions. 

• Exposure to the broad market 

A market index consists of the securities that constitute a sector or market. Thus, investing in a passive fund that tracks the benchmark will expose you to a vast range of securities representing the market movement.

• Easily manageable

If you invest in passive funds, you do not need to track the fund's performance or its fund manager. Since these funds closely replicate their underlying benchmarks, you can expect a return close to your fund's underlying benchmark.

• Transparency

Factors like high-end transparency (just like in active funds) and ease of trade have also contributed to the popularity of passive funds. These funds, especially ETFs, can be sold and purchased anytime on trading. Also, they show all their underlying assets.

Disadvantages and risks associated with investing in passive funds

• Underperformance 

You lose the opportunity to earn higher returns than the market index. The main objective of a fund manager in an actively managed scheme is to help you earn higher returns than the broader market indices. They try to achieve this by using their expertise to decide which stock to buy and when to sell. Since the fund manager is bound to replicate the market index portfolio in the case of an index fund or an ETF, the investors also lose the possibility of earning higher returns.

• Less flexibility

During a market decline, the fund manager does not get the option to change the allocation in the fund's portfolio to lessen the impact of the market slump. This is different from active funds, where we studied that active fund managers respond to market conditions by quickly adapting and changing the portfolio to minimise risk. 

• Tracking errors

Tracking errors are a significant risk for passive funds. These errors signify the inaccuracy of a fund in tracking its underlying benchmark. Thus, if the fund's tracking error is high, it indicates that the fund cannot track its benchmark successfully. 

Factors to consider for choosing a passive fund

• Expense ratio

As discussed earlier, when it comes to a passive fund, the role of fund managers is limited, as they only need to replicate the constituents of the underlying index. Hence, passive funds have a lower expense ratio than their actively managed counterparts.

In the case of passive funds replicating the same index, their cost is a significant differentiator because it affects the return. A passive fund with a lower expense ratio than others tracking the same index will return more. So, pick up the passive fund with the lowest expense ratio.

• Tracking errors

As discussed earlier, if a passive fund cannot match the movements of its underlying index, tracking errors will result. 

For example, a passive fund tracks the Nifty 50. If the fund goes up by 0.90% and Nifty 50 by 1%, this difference would lead to tracking errors. With an index fund aiming to track its underlying index closely, the lower the tracking error, the better the fund.

Who should invest in passive funds?

Investing in funds tracking a broader market index like the Nifty or Sensex makes sense for conservative investors who do not aspire to earn more than the market index. If you yearn to achieve more over extended periods, actively managed schemes should be your option.

Investing in FOFs makes sense only if the underlying fund (in which the FOF invests) is otherwise unavailable easily to you. 

For example, FOFs investing in foreign mutual fund schemes or indices like the NASDAQ have an investment case.

Your Investment Strategy for Passive Funds

When considering an investment strategy for passively managed funds, focusing on your risk tolerance, financial goals, and investment horizon becomes crucial. 

Here are some steps you can follow:

• Identify your goals and objectives: Begin by identifying your financial goals, whether they involve funding your child's education, saving for retirement, or accumulating wealth for a significant purchase. Clarity in setting objectives will help you choose the right mix of passive funds to cater to your investment objective. 
• Diversify your portfolio: Diversification is critical, and passive funds offer an excellent opportunity. Allocate your investments across various sectors, asset classes, and regions by selecting a combination of Smart Beta funds, ETFs, Funds of Funds and index funds. This will help spread risk and enhance risk-adjusted returns.
• Assess your risk tolerance: Choose funds that align with your risk tolerance to ensure you can handle market volatility without jeopardising your financial goals. For this, understanding one’s risk appetite becomes crucial. Some passive funds may have higher fluctuations, while others may provide more stable returns. 
• Have a long-term view: Passive style investing is usually most effective over a longer period. If you maintain a long-term perspective, market fluctuations have a minimal impact on your investments. Avoid reacting to short-term market news and volatility, and stay committed to your passive fund.
• Monitor and rebalance: Review your passive fund investments to ensure their alignment with your risk tolerance and financial goals. Rebalance the portfolio by adjusting the allocation of the fund to maintain the desired level of diversification and risk exposure.

Conclusion

The growth of passive funds in India can be attributed to the increasing realisation of the benefits of low-cost index-tracking investments. The various passive funds, such as index funds, ETFs, Funds of Funds, Smart Beta funds, etc., offer diverse investment opportunities, allowing investors to build a well-diversified portfolio. 

In the previous chapter, we understood that active funds underperformed over a longer period using the SPIVA report. This is a rising concern for the investor community, and thus, more preference towards passive funds. 

By carefully considering your risk tolerance, financial goals, and investment horizon, you can develop a strategy that makes use of the benefits of passive investing.

Overall, passive mutual funds can be a valuable investing tool for the long-term creation of wealth. Thus, it can be a part of any investor's portfolio, delivering consistent returns with minimal costs and effort.