What Are Passive Mutual Funds? Do They Carry Risks?

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Net inflows in index funds and exchange-traded funds (ETFs), which fall under the passive investment category, were about Rs 15,068 crore in August 2022, according to data from the Association of Mutual Fund in India (AMFI).

So, what is passive investing, and do they carry risks? Here we discuss the possible benefits and risks of passive investing.

What Are Passive Funds?

Passive funds don’t change their portfolios frequently, so they buy or hold a stock to gain from the price appreciation of the underlying security over time. 

An example of a passive fund is the Nifty BeES, which tracks the Nifty 50 Index. 

Passive index funds and ETFs track their respective indexes and buy the same stocks or hold until the tracked index’s portfolio construction changes. 

Since passive funds do not involve frequent buying and selling stocks for short-term gains, the fund management fee is generally lower than the actively managed funds. 

Investing in a passive ETF fund requires a Demat account and knowledge of the stock market since its net asset value (NAV) changes every second. On the other hand, passive index funds do not need a Demat account, and you can use them to invest in passive ETFs, which these funds track.

Harish Menon, co-founder and head of Investments and product research at House of Alpha, a financial planning firm, said, “Indian passive fund offerings is one of the widest in the world.” 

The list is quite broad. For instance, passive ETFs are available for large-cap and mid-cap indexes, fixed-income securities, and sectors like banking, auto, etc.

However, passive investing also comes with risks.

Types of Risk 

Returns Not Guaranteed:  Mayur Shah, PMS fund manager at Anand Rathi Advisors Limited, a brokerage and financial services company, said passive fund returns could deviate from the index returns “subject to how liquid the index constituents are” and at “what frequency the constituent can change.” Shah further explained that when the tracked index’s constituents change, the impact cost of the tracking funds changes. “This leads to the tracking error in the funds. The expenses ratio in the funds will further reduce the overall returns compared to the index,” Shah said.

Passive & Active Funds Share Similar Risk: Shah explained that investments in passive or active funds “are subject to market risk. Hence, investors must choose the index funds and ETFs that provide “suitable risk to reward opportunities.”
Menon said, “Passive funds take out the element of active portfolio calls taken by the fund management team, but the money is still invested in stocks. So, when the equity market sees a correction, the market values of passive equity funds will also fall.”

Passive Funds May Fail To Spot Opportunities: According to Shah, passive funds work on the hypothesis that stock prices are fairly valued. “If one believes in efficient market hypothesis, the stock price is assumed to be fairly valued; valuation exercises will not lead to alpha generation. Hence, passive management is to be adopted.”

However, in reality, markets do not value stock fairly and do not become efficient on their own. Therefore, active fund managers try to find hidden opportunities to generate returns (alpha).

“However, markets do not become efficient on their own. It is the actions of participants, sensing profit maximising opportunities and trading on the basis of information using some investment strategy to beat the market that makes markets efficient,” added Shah. 

“Thus, the necessary conditions for a market to become efficient is the belief of the participants that the market is not efficient and they can derive superior risk-adjusted returns by using some schemes or strategies,” added Shah.

Also, while a passive fund may stick to the index stocks, an active fund manager may take investment calls beyond that and adjust the weightage of the stocks in the portfolio according to their convictions. 

How To Invest In Passive Funds?

Menon advises people to “avoid making lump sum investments in passive funds if the investment horizon is less than a couple of years.” For people looking for passive fixed-income funds, Menon advised that “these funds can be considered as a substitute for fixed deposits.” 

He added, “Investors can lock in the yield in passive debt funds with the added advantage of liquidity (since ETFs are traded on stock exchanges) if money has to be withdrawn.”

There is no difference in taxation for passive or active debt funds. Therefore, you may consider investing in passive funds if you want to avoid fund manager risks.

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