Discover the wealth-building power of Index Funds & ETFs

Passive funds and index investing

Let me start with a quiz, what is common between two of the largest fund managers in the world? The answer; they are both predominantly passive fund operators. We are talking of Blackrock and Vanguard, which manage about $17.5 trillion between them. To put things in perspective, that is about 5 times the market cap of the Bombay Stock Exchange. Here is what passive investing is all about.

In a typical diversified equity fund, the fund manager decides what stocks to buy and what stocks to sell. The idea is that, the expertise of the fund manager and team will help the fund beat the index. However, globally close to 85% of the active funds have struggled to beat the index. That has made a strong case for passive investing or index investing. Here is why passive funds are popular; because they can create wealth too. Here is how.

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Indices are easier to predict than stocks

Let us clarify that not every investors or trader can predict the index with accuracy. However, if you look back at the Sensex over the last 40 years, you can assume that the index has given returns of over 16% annualized over the years. That can form a template for the future. However, it is almost impossible to extrapolate stock prices since they are vulnerable to a number of systematic and unsystematic factors. For investors looking at the predictability of returns and wealth creation, index is a predictable choice.

Most active fund managers underperform the index

In the US, it has been observed that nearly 85% of the active fund managers have consistently failed to beat the index. In capital markets this is called the Efficient Market Theory, because as markets become more informed and technologically savvier, most of the information about a stock is factored into the price. When market prices of frontline stocks reflect all triggers, there is little that active fund managers can do to add value.

The benefits and considerations of investing in Index Funds and ETFs

That is the other challenge. Jack Bogle, the founder of Vanguard Funds, has consistently pointed out that the percentage of fund managers outperforming the index is very small. But that is not the problem. The real problem for investors is that it is hard to figure out which fund managers will outperform the market. One way is to look at past performers. That is an acceptable method, but not foolproof. It is here that passive funds offer a much better option.

Low costs are the big selling point for passive funds

The total expense ratio (TER) or cost of a passive fund can be about 180-220 basis points lower than an active equity fund. Since passive funds don’t have active managers, their cost is much lower, which gets passed on to the customer. Let us similar an active fund and a passive fund, over last 8 years. The Active Fund NAV grows 14% CAGR while the passive fund NAV grows 12% CAGR. However, the active fund has TER of 2.50% while the passive fund has TER of 0.50%. What is the impact on wealth creation after 8 years?

The outcomes are quite interesting. Despite generating 2% more than the passive fund each year over last 8 years, the net wealth creation by the active fund is lower than the passive fund. This is due to the passive fund saving on costs.

Passives fit seamlessly into financial planning

This is perhaps the most important, and less discussed, reason why passive funds create wealth. Financial planning is about future goals and an investment plan designed to achieve these goals. Long term goals presuppose that the funds you own should be more predictable and passives fit that bill to perfection. While monitoring passive funds, the last thing you worry about is fund manager decisions. 

Passive investing is growing rapidly and is more than 15% of mutual fund AUM today. As of now, India still offers Alpha opportunities in the mid-caps and small-caps. But, passive is certainly an idea whose time has come, as it creates genuine value to investors.