Mitigating the Unsystematic Risks with Passive Funds
When we discuss mutual funds, we come across the standard warning when, “mutual fund investments are subject to market risks.” However, such risks can be classified into two categories – systematic risks and unsystematic risks. Systematic risks arise because of macroeconomic changes in the domestic and global economy. Such changes can include economic growth, fiscal deficit, current account deficit, forex movements, etc. On the other hand, unsystematic risks can be all other risks, other than the systematic risks. Such risks can include the risk of selecting a wrong company for investments or investing in a company at higher valuations etc. As such, unsystematic risks can be majorly attributed to the investment decisions made by the fund manager.
While an investor may be cautious in investing in quality companies with good performance and track record, there might be situations like economic slowdown, terrorist attacks, etc, which may affect the overall market condition. Even the quality investments may suffer on the back of bearish sentiments in the economy. As such, managing systematic risks can be difficult. On the other hand, unsystematic risks can be mitigated with better research and investment decisions. It can be accomplished even better if the decision-making power of the fund manager is taken away from them while giving them a broad investment mandate. As such, passively managed mutual funds can help in mitigating such unsystematic risks for the investors.
Passive funds are the kind of funds that follow passive investing strategies instead of active management of the investment portfolio. In other words, such funds tend to replicate an underlying index and, thus, provide similar returns as that of the underlying index. Exchange traded funds (ETFs) and Index funds are commonly used passive investment products by the investors. For example, if an investor wants to generate returns similar to that of S&P BSE Sensex, the investors have two options. One is to create an investment portfolio with similar stocks in the same weight as that in the index, and the second option is to invest in Sensex ETF. Since investing in ETF is more convenient and easier, the investors will prefer to invest in ETF to achieve that investment objective.
Since passively managed mutual fund schemes can only replicate the underlying index, the fund manager has a limited role to play in the overall investing decisions for the fund and is restricted to tracking the changes in the index composition. Barring that, the fund manager has no flexibility or liberty to modify the portfolio composition. As such, the passive mutual funds trust the index composition to generate better returns for the investors. Given the lesser role of the fund management team into the overall investment functions, passive funds tend to have lower TER (Total Expense Ratio). The passive funds will tend to have a zero alpha, as the investment performance will move in tandem with the returns of the benchmark index, subject to tracking error. However, since the benchmark indices are constructed through scientific models and can be considered as a fair representation of the overall market sentiments, investing in passive funds provides diversification to the investors across the market segments through a single investment product.
Managing your investments is all about managing investment risks. While passive funds mitigate the unsystematic risks for the investors conveniently, such funds also help the investors in achieving portfolio diversification with low costs. As such, the investors can consider investing in passive funds to have investment exposure across the broader markets and generate wealth over the long term.