What you actually need to know about passive investing

Passive investing, as the name suggests, is all about avoiding active stock selection when it comes to your investment. Typically, when you plan to invest in equities, there is a lot of homework that is required. You need to first short list the companies you want to invest in, then you need to be certain that these companies fit into your long-term financial goals and finally you need to monitor the performance of these stocks once you invest in them. This is called active investing wherein you actively participate in the investment process. What if you want to adopt a passive approach to investing in equities?

How does the idea of passive investing fit in?
Passive investing is based on the idea that stock markets are generally an efficient market place. When we say efficient we mean that the information dissemination happens rapidly and therefore stock prices tend to reflect all the positive and negative news that are relevant to the stock. Therefore the stock price, at any point of time, is supposed to reflect all the financial and non-financial projections pertaining to the company. This argument is stretched further to prove that since markets are efficient there is nothing like the opportunity to buy underpriced stocks or sell overpriced stocks. Since stock selection and stock monitoring becomes redundant, the idea is that you can be better off investing your money passively through an index fund or similar such products.

Two different levels of passive investing..
Globally, passive funds manage a lot more money compared to active Mutual funds. While passive funds are just about gaining acceptance in India it is a highly matured industry in other countries. In fact, there are large mutual fund houses like Vanguard which purely thrive on passive management of funds. Broadly, there are two levels of passive stock market investing as far as an investor is concerned..

There is passive investing to the extent of your relationship with the management of the money. When you typically hand over money to a mutual fund or a portfolio manager to invest the money on your behalf, it is a kind of a passive relationship between you and your money. You rely on the discretionary investment skills of the fund manager and only judge the performance based on the outcome. This is passive in a very elementary form.

A more acceptable definition of passive investment is when the end use of funds is done in a passive manner. For example an index fund or an index ETF are examples of passive investing. Here the fund manager only worries about keeping your tracking error to the minimum possible level and tries to replicate the index as closely as possible. For example, if you had bought an index fund when the Nifty was at the 4500 level in 2012, then the index fund would have returned more than 100% or nearly 15% CAGR over the last 5 years. This return would have come at a very low cost and with minimal stock selection risk.

 
The gist of the active versus passive argument..

As the graphic above depicts, there are some key areas of difference between active and passive investing and there are some strong arguments in favour of passive investing. Here are a few of them..
We know that investing is all about two kinds of risk viz. the unsystematic risk and the systematic risk. Passive investing ensures that all the unsystematic risk is automatically diversified away and the only risk taken is the systematic risk, which is measured by Beta.
The key difference is on costs. Active management entails costs in the form of marketing, selling the idea, fund manager fees, active trading costs etc. Passive investing reduces most of these costs substantially and that makes a huge difference over the long run.
While we get to hear of the outperformance of star money managers like Warren Buffett, Peter Lynch, Carl Icahn and Ray Dalios, the fact is that that a much greater percentage of fund managers tend to underperform the index, making passive investing lot more meaningful.
Passive investing is free from bias. The big challenge in active investing is to eliminate the individual bias and style that comes in and impacts the eventual performance. By adopting a rule-based approach, passive investing overcomes this major hurdle.

Are there any clear answers to the active versus passive debate?
Frankly there are no clear answers to the active versus passive debate. Currently, Indian markets still offer substantial opportunities for managers to earn alpha (excess returns). That is perhaps one of the reasons why passive funds have not really taken off in the Indian context. However, it is very likely that as markets mature and alpha opportunities reduce passive investing will take off in a much bigger way. As a starting point, one can look to make a small 15-20% allocation out of the equity allocation to passive investing. In volatile times, it will offer a degree of stability to the portfolio at the very least!