Index Funds and Passive Investing

Passive investing has caught a lot of attention in India and abroad over the last decade. With passive investing, the investor aims to earn market returns.

It removes the element of market timing and doesn’t attempt to outperform the market. Index mutual funds or exchange-traded funds (ETFs) are the 2 main passive investing products. This article will explain index funds, passive investing, and their benefits.

What is Passive Investing?

Passive investing is an investment strategy in which an investor buys and holds a diverse mix of securities for the long term. There are either no or very few transactions of buying and selling of securities in the portfolio. With passive investing, the investor aims to earn market returns. It removes the element of market timing and doesn’t attempt to outperform the market. Passive investing is simple and involves lower costs.

Index Funds

A popular way of passive investing is to invest in an index fund. An index mutual fund scheme is an open-ended mutual fund scheme tracking an underlying index. As per SEBI guidelines, an index fund has to invest at least 95% of its total assets in the underlying index securities. Index mutual funds invest in an index like Sensex or Nifty 50 in the proportion of their weightage in the index.

In short, an index mutual fund scheme mirrors the performance of the underlying index that it is tracking. The net asset value (NAV) of index funds goes up or down, corresponding to the rise or fall in the levels of the underlying index.

The Growing Popularity of Passive Investing

John Bogle of Vanguard started the concept of passive investing through index funds in the US. In 1976, the company launched Vanguard 500 Index Fund, its first index mutual fund. Today, it is one of the world’s largest mutual funds with an AUM of $4 trillion in index funds worldwide (Source: Vanguard.com).

Looking at the growing popularity of Vanguard index funds, other mutual funds also started offering index mutual funds, and they were received well by investors. Over time, active fund managers have found it difficult to generate alpha and steadily lose market share to passive funds.

US-USA-Market Funds

(Source: Reuters; US-USA-Market Funds)

As can be seen from the above chart, in the US, passive funds have outperformed active funds in price returns in 9 out of the last 10 years. The inflection point came in August 2019 when passive funds (with AUM of $4.271 trillion) surpassed active funds (with AUM of $4.246) by $25 billion

(Source: Investopedia).

The growing trend of passive investing is visible outside the US also. In Japan, index funds overtook active funds for the first time in January 2020.

Index Funds overtake active funds

(Source: Asia -Nikkei; Index Funds overtake active funds for the first time in Japan)

The legendary investor Warren Buffet also advocates investing in index mutual funds. In 2013, in a letter to Berkshire Hathaway shareholders, he wrote:

“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions, or individuals – who employ high-fee managers.”

Growth of Passive Investing in India

In India, active mutual funds have been the preferred way to invest in mutual funds for a long time. While active mutual funds continue to dominate, passive investing has been picking pace for the last few years.

Quarterly data for the quarter October – December 2020
Scheme NameNet AUM as on 31st December 2020 (Rs. in crores)
Index Funds15,259.14
Gold ETFs14,173.85
Other ETFs2,56,237.20
Fund of funds investing overseas9,062.19
Sub Total2,94,732.38
Grand total for all categories31,02,475.50

(Source: AMFI)

As per the Quarterly data released by AMFI for Oct-Dec 2020, index funds have garnered an AUM of Rs. 15,259 crores and Other Exchange Traded Funds – ETFs (equity and debt ETFs) have garnered an AUM of Rs. 2.56 lakh crores as of 31st December 2020.

While passive investing still has a share of less than 10% in the overall mutual fund industry AUM of Rs. 31 lakh crores, the passive investing trend is picking up pace.

Benefits of Investing through Index Funds

Investing through index funds offers a lot of benefits some of which include:

1. Low Fees

An index fund invests in all the constituents of the index in specified proportions. There are minimal changes only when the composition of the index changes. There is no effort on the part of the fund manager to identify which stocks to invest in. Due to all the above factors, the expense ratio of index funds is much lower than that of active funds.

2. Diversification

An index fund with an underlying index such as the Nifty 50 provides adequate diversification to the investor. The Nifty 50 index represents 50 companies spread across 13 sectors of the economy.

3. Transparency

Index funds offer complete transparency. Information related to the underlying index constituents and their respective weights is available in the public domain and accessible for anyone.

4. Tax-efficient

Investing in an index fund involves a buy and hold strategy. Since an investor would usually invest for the long-term, short-term capital gains (STCG) would not arise. The long-term capital gains (LTCG) tax will be charged at 10% for LTCG arising after a holding period of 1 year.

Passive Investing has a Bright Future in India

As investor interest in passive investing is picking up in India, mutual fund houses also broaden their index fund and ETF offerings. It will be challenging for active fund managers to generate alpha in the future with improving market efficiency.

Hence, investing in low-cost index mutual fund schemes and ETFs will make sense for investors.

To accomplish your financial goals, partner with the Glide Invest App today and start investing in index mutual fund schemes.

 

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About FinanceGAB

Ajeet Sharma is a financial blogger and I am blogging since 2017. Financegab is a personal blog dedicated to personal finance. The main aim of this blog to help people to make well-informed financial decisions.
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