What is Passive Investing and What are its benefits?
Passive investing refers to an investment strategy of creating an investment portfolio that has a similar composition as an underlying index such as S&P BSE Sensex, NSE Nifty50 or a commodity, such as Gold. In passive investing, the investors invest with intent to replicate the returns of the underlying index/commodity. As such, the investors have direct exposure to the benchmark indices and commodities through a single investment product. Examples of investment products that adopt such an investment strategy are Exchange Traded Funds (ETFs) and Index Funds.
Passive investing strategy is based on the premise that indices have been created based on a scientific and robust index construction methodology. This eliminates emotional bias in the process of portfolio building. The index tends to include the companies with a proven track record, and thus, the investors generally stay inclined towards having an investment exposure in such companies. However, the indices are not tradable security by themselves and replicating the index composition is a big challenge for retail investors. As such, replicating such a portfolio may turn out to be a high-cost investment option with a potential of better returns for the investors.
Considering that passive investing must replicate the benchmark index, the fund managers have a limited role to play. They are restricted only to tracking the changes in the underlying index. Apart from that, there is no flexibility with the fund manager to alter the portfolio composition. This is in contrast to the active investment strategy, wherein the fund management team aims to explore various investment opportunities available in the market and benefit from the market fluctuations. On the other hand, passive investing relies upon the benchmark indices to generate better returns for the investors in the long run.
As such, the investors tend to have a zero alpha with the investment products managed with passive investment strategy, since the performance of such products will replicate the benchmark indices, subject to the tracking error. Tracking error refers to the difference between the time of changes in the index composition and the time when the changes are reflected in the portfolio composition.
Benefits of Passive Investing
Lower Costs – Passively managed investment products like ETFs, index funds etc. tend to have lower expense ratios as compared to actively managed funds. This is because the investment team has almost negligible role to play in terms of selection of stocks and determination of investment timing considering the need of only tracking the changes in the composition of benchmark indices. Consequently, the fund management charges and transaction costs are minimal, thereby resulting in lower costs for the investors.
Diversification – Since the benchmark indices are constructed to have an overall market representation, comprising of different sectors and segments of the market, investing with a passive investment strategy passes the same benefits of diversification across the market segments through a single investment product.
Elimination of unsystematic risk – Systematic risk is the risk of market movements due to changes in the macroeconomic indicators like economic growth, current account deficit, etc. Unsystematic risk refers to the risk other than the systematic risk. In other words, it is the risk of selection of wrong investment products or improper timing of investments in the mutual fund scheme. Since the passive investment strategy does not render such flexibility to the fund managers, such risks stand mitigated for the investors.
How to Invest in ETFs (Exchange Traded Funds) and Index Funds?
ETFs (Exchange Traded Funds) may be traded on stock exchanges like other stocks. The investors may invest in ETFs by placing a buy order on the Stock exchanges through their Demat trading account. Similarly, the investors may invest in index funds by following similar procedures like they invest in other mutual fund schemes, i.e., by investing physically through submitting the application at authorized centers or by investing through the website of the mutual fund house.
Building a well-diversified portfolio is crucial for a smooth and successful investing journey, and passively managed products are indeed a great way to achieve such diversification with low costs.