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Do you know about passive funds?

There is a type of equity mutual fund you can invest in which charges you just 0.05% (annual) or 5 paise per ₹100 of investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains.... What you get is a portfolio of good quality, large cap stocks which can be held for long term wealth creation.

You may have heard the term exchange traded funds or ETFs, these are the super low cost equity schemes I am referring to. 

The average annual cost of investing in an ETF is around 0.2%. Some of the popular ETFs linked to indices like Nifty 50 and Sensex 30 are available at 0.07% as compared to 1%-1.3% annual expense for some of the largest actively managed equity funds.

Passive Funds

What are ETFs? They are essentially known as passive equity funds, which means there is no active involvement by a fund manager in selecting stocks or in changing the portfolio. Then how is it of good quality? The portfolio mimics or copies the portfolio of an established market index. For example, there could be an ETF based on the Sensex 30; it will have the same stocks that comprise the Sensex in the same proportion. Similarly, there are equity ETFs modelled around the Nifty 50, BSE 100, Nifty Junior and so on. These are professionally managed indices where quality control is inbuilt.

The lack of fund manager involvement is primarily the reason for low cost of this product. It also removes the risk you run of poor choices or fund management decisions. Pension funds in India have recently subscribed to equity ETFs as well for their long term holding and that is another reason for such low cost for this type of fund.

Why it works?

The cost or expense in a mutual fund scheme is deducted from the gains of the scheme itself. Which means, lower the cost, higher the gains. Moreover, in the recent past, specifically for the large cap category of equity funds, ETFs have successfully outperformed active managers.

Sample this: the average rolling return of Sensex 30 and Nifty 50 based ETFs for a 1-year and 3-year period is 9.8% and 14.1% respectively. This is certainly more desirable as compared to similar period average rolling return for schemes in the large cap category (direct plan) at 3.9% and 12.2%. 

This overtaking of ETF returns compared to actively managed funds in the large cap space is a recent phenomenon; 5-year average for actively managed funds stands at 15% as compared to 13% for ETFs based on Nifty 50 and Sensex. This change has come about thanks to three main reasons:

1. Narrow equity rally where only 4-5 large cap stocks from benchmark indices like Nifty 50 and Sensex 30 have contributed
2. Global institutional investor shift towards beta-based investing as compared to reliance on stock selection in funds, thus pushing up the demand for ETFs and consequently positive for stock prices of heavy weights in underlying indices. 
3. Redefined universe of stock selection and market cap weights for large cap funds post MF recategorization by SEBI. This has standardised the stocks available in this category and made the overall large cap universe of stocks narrow.
4. Drastic fall in cost of ETFs over the last 2-3 years.

The first two are driven by market forces and thus, beyond control; it’s the third and fourth points which are likely to continue putting curbs on the ability of fund managers to consistently outperform the underlying benchmark. Hence, ETFs which mimic these benchmarks can potentially continue to outperform their actively managed counterparts.

Given this trend of relative performance of ETFs over active funds in the large cap category, there is merit in including this type of scheme in your long-term equity allocation.

When you are just starting out your investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... journey, might as well think of long-term return optimisation. A big component in that is expenses. Over the long term, just like returns compound, expenses compound too. By investing in ETFs, you save yourself high expenses, at the same time returns don’t suffer thanks to the underlying index. Plus, in this category there is no distinction in direct or regular plans, saving you the additional headache of making that choice!

HOW LIKELY ARE YOU TO INVEST IN ETFs? SHARE YOUR THOUGHTS IN THE COMMENTS SECTION BELOW.

What should the proportion be?

There is one golden rule in investing, which must be followed at all times – diversification. Hence, you needn’t invest all you got in ETFs. What you should consider is apportioning some of what you will invest in equity assets, in ETFs. How much? Begin with 20-25%. That seems like a high commitment to one type of product. However, keep in mind this is a portion of your equity investments not your entire portfolio of investments. Within equities, too much diversification will not add incremental benefit in terms of return – rather you may just end up adding more risk. 

With the remaining 75%-80% you can add mid cap stocks or funds. Keep in mind this is a low-cost high return investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... which needs to slow cook for 10-15-20 years. 

How can you invest?

It’s good prudence to take the help of a registered, qualified and experienced advisor. 

You can buy ETFs from the mutual fund’s website. For example, you can buy SBI Sensex ETF from SBI Mutual Fund’s website or Reliance Nifty BeES from Reliance Mutual Fund’s website and so on. Many online mutual fund distributors will not offer ETFs. However, if you have a broking account, online or otherwise, you can buy ETFs through those. 

PS – The names of funds are not recommendations.

Leaving you with this table showing simple ETFs which have the lowest expense ratio and the highest assets under management. Soak in their performance stats and give this type of financial investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... a serious thought. Also, remember each ETF which is based on the same underlying index will have mirroring portfolios, hence returns will be almost the same; your deciding factors for investing should be expenses, your brand preference and lastly, assets under management.

Notes
Rolling returns considered over the last one year as on 15th July 2019
Expense Ratio as on 30th June 2019
# Expense Ratio as on 31st March 2019
Assets under management as on 30th June 2019
Source – Valueresearchonline.com