What to keep in mind when investing in passive funds?

In India passive investing from a mutual funds perspective is available in various forms. There are index funds, index ETFs, gold ETFs, debt ETFs and international fund of funds (FOFs).

Nov 23, 2021 08:11 IST India Infoline News Service

Passive investing is slowly but surely coming of age in India. In India passive investing from a mutual funds perspective is available in various forms. There are index funds, index ETFs, gold ETFs, debt ETFs and international fund of funds (FOFs). These five passive categories broadly constitute passive investing in the Indian context.

Why Passive Investing?

This was best summed up by the father of passive investing, John Bogle. The founder of Vanguard rightly said, “Why to look for a needle in a haystack, when you can buy the entire haystack.” That is what passive investing is all about. You identify an index or a proxy and just buy that proxy.

Consider these numbers. Between 1979, when the Sensex was launched with value 100 and the year 2021, the Sensex is up more than 600 times. That is a CAGR of 16% over 42 years. If you add the dividend yield, it would be closer to 17.5%. That is an incredible return from just buying the index. There is a more practical side to the argument.

We have seen in the US, and nowadays it is visible in India also, that consistently beating the index is not possible. Even if some funds manage to beat the index, it is difficult for the investors to identify such funds. A better option is to buy the index as a passive investor.

How has passive investing grown in India?

The table below captures the monthly flows into passive fund categories for the 7 months of FY22 and the cumulative AUM of passive funds.

Month Indexing Gold ETFs Debt ETFs FOFs Passive AUM
Apr-21 Rs1,168cr Rs680cr Rs2,537cr Rs695cr Rs327,615cr
May-21 Rs1,241cr Rs288cr Rs5,380cr Rs2,424cr Rs355,337cr
Jun-21 Rs1,687cr Rs360cr Rs3,013cr Rs792cr Rs365,355cr
Jul-21 Rs1,111cr Rs-62cr Rs6,545cr Rs2,490cr Rs377,474cr
Aug-21 Rs1,935cr Rs24cr Rs8,548cr Rs1,085cr Rs412,134cr
Sep-21 Rs3,104cr Rs446cr Rs7,660cr Rs410cr Rs434,225cr
Oct-21 Rs3,514cr Rs304cr Rs5,427cr Rs1,514cr Rs449,186cr
Overall AUM Rs37,528cr Rs17,321cr Rs370,336cr Rs24,001cr
Data Source: AMFI

This is an interesting data set on passive flows in FY22. There are two interesting inferences. Firstly, over the first 7 months of FY22, in just one month there were negative flows in gold funds. In all other cases, it has been positive flows all along. Secondly, the AUM of passive funds as a category has gone up by 37% in last 7 months, largely dominated by debt ETFs.

As much as passive investing is simple, economical and appealing (like buying the haystack), any surge in buying interest calls for understanding what to do and what not to do with such passive funds that are benchmarked to indexes.

Passive investing is about beta gains, not alpha

This is the crux of passive investing. You are buying the haystack and hence you are automatically agreeing to forego active returns. Here are some important points to remember when investing in passive funds.
  1. Passive funds are economical because they do not need expensive fund managers to take expensive decisions. The fund is just pegged to an index or a benchmark and the returns on the passive fund mirror the underlying index. The logic is that any index of robust assets gives good returns over a longer period of time. Hence, lower costs can boost these returns geometrically.
  2. It logically follows that indexing or passive investing is not for the short term. For example, indices may literally not go anywhere for a period of 2-3 years. Unless you take a longer term perspective of 8-10 years, it is hard to seriously look at passive investing as an asset class.
  3. Passive funds are great portfolio diversifiers and portfolio reallocators. For example, if your equity ownership has gone up substantially more than allocation, you need to add debt to bring down the equity share. An easy method to add debt or gold to your portfolios is by buying a passive debt index ETF or a PSU debt ETF or even a gold ETF.
  4. Financial planning normally begins with asset allocation. One way is to execute your asset allocation through passive funds. For example, between index ETFs, debt ETFs, gold ETFs and FOFs, you have coverage of four of the most popular and lucrative asset classes. Now, all that you need to do is to allocate to these passive avenues.
  5. Last, but not the least, you must remember that in investing you either run with the hares or hunt with the hounds. When you invest in an index fund, your only focus should be track the index and reduce the tracking error to the extent possible. Don’t buy the fancy ideas like Index Alpha funds and Beta Plus funds. You can as well opt for an active fund. If you are opting for a passive fund, let it be actually passive.
As passive investing takes off, these are some ground rules to follow. In his 2016 Berkshire Hathaway letter to shareholders, Warren Buffett had fulsome praise for John Bogle for saving half a trillion dollars in costs for retail investors. That is the real idea of passive investing.

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