Things to Consider While Investing in a Passive Fund

For a market capitalisation-based approach, one can consider passive funds with a long-term perspective

Things to Consider While Investing in a Passive Fund
Things to Consider While Investing in a Passive Fund
Chintan Haria - 19 July 2021

When it comes to investing, an investor has two choices, either to invest in an active fund or a passive fund. While actively managed funds have been thriving for over two decades, passive investing over the past couple of years has been gaining traction among investors in India.

Options available:

Passive investors have a plethora of options to choose from ranging from plain vanilla ETFs (Sensex, Nifty 50, Nifty 100, Nifty Next 50, Midcap 150 and S&P BSE 500), Smart beta ETFs (Nifty Low Vol 30, Alpha Low Vol 30, NV20 ETF), sector/thematic based ETFs (Banks, Private Bank, IT, Healthcare) and index funds (Nifty, Nifty Next 50, Sensex). These offerings are spread across equity, debt (Liquid ETF) and gold (Gold ETF) asset classes. Thus far, indices based on market capitalisation have emerged as the most popular choice among retail investors.

Things to be mindful of when choosing the fund:

1) Scheme Selection

When it comes to investing in passive funds, including smart beta funds, an investor is basically investing into an index based on which the fund is created. So, as an investor, one should closely check the index to ascertain if one’s investment objective and diversification needs are met or not.

If you are an investor looking for broad based market participation, then one can consider investing in products based on indices such as Nifty 50 or Nifty 100. If the need is towards a broader market, then there are scheme mid and small cap indices which can help achieve this requirement. There are also thematic/sectoral offerings which a savvy investor can consider. Similarly, through Gold ETFs an investor can take exposure to gold.

2) Tracking Error

This is one of the parameters through which an investor can evaluate a passive offering. Given that a passive fund replicates an index, it is expected that the returns profile too will be replicated. Tracking error is the difference between the scheme’s return and the benchmark index’s return. For example: If a Nifty 50 index has generated 15 per cent return and the fund which replicates this index generated a return of 14.95 per cent, then the tracking error in this case is 0.05 per cent. Ideally, when making an investment choice, opt for a fund which has the lowest tracking error. This difference could be on account of expenditure incurred by the fund, cash balance or portfolio deviation. All of these details are disclosed by fund houses in their respective monthly factsheet.

3) Expenses

One of the trump cards of passive funds is that it is a cost-effective way of investing. The low-cost structure is made possible because the fund replicates an index and the role of a fund manager here tends to be very minimal. While cost is an important parameter, it should not be the primary driver when it comes to decision making.

4) Liquidity

One of the common misconceptions when it comes to ETFs is the lack of liquidity. However, liquidity on the ETF exchange has improved significantly over the last three-four years as investors are increasingly opting for passive investment options on account of increasing awareness about the product offerings.

When it comes to portfolio construction, the ideal approach is to have a blend of active and passive funds. For a market capitalisation-based approach, one can consider passive funds with a long-term perspective. Similarly, a savvy investor looking for factor-based investing (rule based with specific investment strategies) too can consider going the passive way.

The author is Head - Product Development and Strategy, ICICI Prudential AMC.

DISCLAIMER: Views expressed are the author’s own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.

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