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?Passive Investing | Let the index make money for you | Money Bites Newsletter 05 Mar

Written by - Akshatha Sajumon

March 5, 2021 6 minutes

Money Bites

Short bites to keep you informed of matters that impact your wallet and wealth

Hey there,

Hope you are doing well!

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Top Bite this Week

Is passive investing the way to go for retail investors?

What’s going on here?
There is a lot of news and interest around passive investing in the Indian markets with new funds being launched in the space.

What’s passive investing? How is it different from the mutual funds we usually know?
Let’s take a moment to go back to see how a mutual fund works. It’s basically a pooled investment that is managed by a fund manager for a fee. The fund manager invests in various financial assets in line with the objective of the fund to generate returns for investors. All funds are tied to a benchmark to measure its performance. All actively managed mutual funds look to beat the benchmark and generate good returns for their subscribers. As beating the benchmark is the goal, the fund manager can buy and sell securities as and when required.

However, passive investing takes a differing viewpoint. It believes in the power of the market to do the job of creating returns for you. What is the market you may ask? It is nothing but the Index which is a benchmark for the market it represents, like the Sensex which is a benchmark for the stocks traded on the Bombay Stock Exchange, and Nifty for the National Stock Exchange. The stocks on the index are selected based on criteria set by the exchanges which include diversification and liquidity among others.

Passive investing advocates that you can generate good returns on your investment by investing in or mirroring the Index, in the exact same stocks in the exact same proportion. So how do you do that? It’s simple! There are index funds or Exchange Traded Funds that invest in the stocks/other assets on any particular index they aim to mirror. Index funds work just like any other mutual funds and ETFs are like a combination of mutual funds and stocks. Index mutual funds are bought from and sold to the mutual fund companies(AMC) and ETFs are traded on the stock exchanges. All you go to do is to buy and hold these funds over the long term.

What makes passive investing worth it?
If you look at it, as passive investing involves mirroring the index there is no frequent buying or selling of any other stocks. Only a change in the constituents of the index would require changes and this doesn’t happen frequently. As the fund just needs to buy, hold, and mirror the index, it doesn’t need the services of an army of fund managers and other specialists to cherry-pick stocks.

Moreover, with the SEBI reclassification rules on the categorisation of mutual funds, insistence on benchmarking to the Total Return Index, and capping the expense ratio, active fund managers may find it difficult to generate returns over and above the benchmark. In fact, a scorecard by S&P shows that many of the funds( in the large-cap & ELSS category) underperformed the Index during the first half of 2020.

How does passive investing affect your wallet?
You might have already guessed it, the costs involved in the management of an index fund/ETF are much lesser. To give you some numbers, the average expense ratio on large-cap funds stands at 2.24% vs 0.67% for Nifty or Sensex funds. When compounded over the long term, this difference can make a big impact on the returns you can make. So, it may be time for you to sit back and relax and let the Index do the job for you.

You Ask – We Answer

I have saved money from my income but never invested. How should I start investing? – Manish

This is a question that many beginner investors have on their minds.

Let’s start with understanding why investment is important. Investment is required because you could need money to meet various goals like retirement, buying a house/vehicle, travel, or anything else. Saving is easy, but the money that you save doesn’t grow when you keep it in your savings account as inflation eats off your saved money. So you must invest at a rate higher than the inflation for your investment to be worth it.

To start investing, set your goals and see how much money is required to meet the goal. Then you will have to work backward to see how much should you start putting aside every month/year to reach that goal. The money that you put aside could be invested in various assets like fixed deposits, recurring deposits, provident funds, NPS, mutual funds, direct equities, or real estate. This choice of investment avenue will depend on the time frame of your goal and your risk appetite. For eg: Equity mutual funds can be suitable for long-term goals like retirement or children’s education, while debt mutual funds will work for short-term goals like buying a car/bike in the next 2-3 years.

? Do you have questions on personal finance & investing? Go ahead and ask away in the comments. Get featured in our upcoming issues.

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We look forward to your thoughts, story ideas, recommendations, or questions. Please leave your comments.Do share this newsletter with your friends & family!

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