Home Finance Why Passive Funds Are A Good Choice For New Investors?

Why Passive Funds Are A Good Choice For New Investors?

by Paul Watsdon

Mutual funds are a modern investment vehicle that are supposed to offer capital appreciation over the long term. Mutual funds pool funds from investors sharing a common investment objective and invest this pool of funds across the Indian economy. Mutual funds allocate assets in a diversified manner in quantum with the scheme’s investment objective. Some of the money market instruments where a mutual fund invests are stocks, government securities, corporate bonds, company fixed deposits, certificate of deposits, debentures, gold etc.

Market regulator SEBI has further categorized mutual funds depending on their investment objective, asset allocation, investment strategy, risk profile etc. The main motive behind this categorization is to help investors take an informed investment decision. One good thing about mutual fund investments is that even a ‘know nothing’ investor (as described by Warren Buffet) can invest in these funds and seek capital appreciation. Having said that, investors, whether new or seasoned ones, are expected to determine their risk appetite while making an investment in market linked schemes like mutual funds.

There are major two types of mutual funds which are further categorized. These are actively managed mutual funds and passively managed mutual funds. Actively managed funds are those mutual funds that involve active participation of the fund manager. It is the duty of the fund manager/managers to devise an investment strategy and buy/sell securities in quantum with the fund’s investment objective. When you invest in actively managed funds you are entrusting your money in the hands of the fund managers. A mutual fund is a combination of different asset classes and money market instruments. The fund managers make sure that they diversify the mutual fund portfolio in such a manner that the scheme succeeds in outperforming its underlying index.

A passively managed funds fund on the other hand does not involve active participation of the fund manager. The investment objective of the scheme is to seek capital appreciation by tracking its benchmark or underlying index. Market regulator SEBI (Securities and Exchange Board of India) defined passively managed funds like index funds or ETFs (exchange traded funds) as those who “replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc These schemes invest in the securities in the same weightage comprising of an index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as “tracking error” in technical terms. Necessary disclosures in this regard are made in the offer document of the mutual fund scheme.

There are also exchange traded index funds launched by the mutual funds which are traded on the stock exchanges.”

Why are passive funds ideal for new investors?

There are several reasons those who are new to investing should invest in passive funds. Firstly they replicate the performance of the underlying index. For example if you invest in gold funds the performance of the fund will depend on how international gold prices fluctuate. There is no active participation of the fund manager unlike in actively managed funds. This is the reason why the expense ratio for owning a passively managed fund is far more less as compared to actively managed funds. Some actively managed funds have an expense ratio that goes as high as 2.5 percent or even above. On the other hand the expense ratio of owning a passively managed fund is generally below 2 percent.

If you do not possess a deep understanding of mutual funds but are still keen on generating income over the long term through investments in these market linked schemes, you may consider investing in passively managed funds.