What are the different types of passive investment strategies to adopt - Motilal Oswal
What are the different types of passive investment strategies to adopt - Motilal Oswal

What are the different types of passive investment strategies to adopt

What do we understand by passive investment strategies in the markets? To put it simply, passive strategies are the opposite of active strategies. In active investing, the fund manager or the portfolio manager takes immense pain to do in-depth research into companies and identify stocks that can actually outperform the market. The cost of active investing is much higher and therefore the return expected on active investment funds is also much higher.

So what is passive investing and what are the best passive investment strategies? What are the various types of passive investment strategies. Passive investing does not try to beat the market but just tries to mirror the market. So you earn as good or as bad as the index (Nifty or Sensex). That is not bad considering that the Sensex is up 350 times in the last 37 years while the Nifty is up over 11 times in the last 23 years. But why is there a shift towards passive investing globally? Above all, what are the passive investment strategy benefits?

 

The big shift towards passive investing..
The big merit of passive investing is that the costs are much lower. You do not require analysts to identify stocks and you not require dealers and fund manage to create alpha. These lower costs get passed on to the end customer. Consider the chart below..

 

                                    Chart Source: Morningstar

 

The above chart captures how passive funds are getting massive inflows in the last 10 years but what has really reversed is that active funds are seeing massive outflows. As Buffett himself pointed out in his 2017 letter to shareholders, passive funds are increasing giving a tough time for active funds due to a combination of limited alpha opportunities and the substantially lower costs of passive funds. It is hardly surprising that two of the largest asset managers in the world, Blackrock and Vanguard (that jointly manage nearly $9 trillion between them) are essentially passive investors. So why has this shift towards passive investing happened so sharply?

 

Why this shift towards passive investing globally?

 

                                Date Source: Standard & Poor

 

The above table is an interesting summary of how active managers have performed vis-à-vis the indices over different time frames. The data shows that across all the 3 time frames of 1-year, 3-years and 5-years, the passive index has outperformed more than 90% of the active fund managers. The real challenge for an investor is how to choose a fund manager who will fall in the balance 10%. That is why passive investing is becoming a lot more popular among investors. The point is why investors should opt for active funds when the outperformance ratio is so low and there is not sure-shot method of identifying these outperformers.

 

Types of Passive Investment Strategies:
As the name suggests, passive investing is all about tying down to your portfolio to an index or an ETF. There are four ways of creating a passive investment strategy in the Indian context..

You can have a passive approach even in direct equities. An equity investor can create a passive strategy by buying up all the index stocks in the same proportion as the index. By doing that, your portfolio performance will approximately reflect the performance of the index (Nifty or Sensex) over a longer period of time. The real challenge is something different. For an individual that can be quite complicated as he will have to track index changes, weightage changes, corporate actions etc.

A simpler way to replicate the above will be to directly buy an index fund, which is offered by many mutual funds in India. An index fund buys up the entire index stocks in the same proportion as the index. The fund manager manages the tracking error and ensures that the fund performance is as closely aligned to the index as possible. Index funds can be bought from the mutual fund houses, from distributors or even online. The big advantage of index funds is that costs are very low compared to active funds.

ETFs are a slight variation of the index fund. Like an index fund, the ETF also creates a portfolio of index stocks in the same proportion. The only difference is that the ETF is listed on a stock exchange and can be bought and sold on any recognized stock exchange. When you buy or sell an ETF, it only leads to transfer of ownership and not to shift in the AUM of the ETF. Additionally, ETFs are also available on other benchmarks like ETFs on gold, ETFs on silver, ETFs on equity indices, ETFs on debt market indices etc. ETF units can be bought and sold through your existing equity trading account and can be held in your regular demat account.

There is a slight variation of passive investing which entails buying and holding a portfolio of dividend yield stocks. Dividends are tax-free in the hands of the investor up to a limit of Rs.1 million per year. Thus a stock that offers a dividend yield of 6% will actually be paying an effective tax- adjusted return of {6%/(1-0.3)} = 8.57%. Most high dividend yield stocks are saturated stocks and hence the volatility risk is quite low in such stocks.

The moral of the story is that there is a lot of wisdom that investors are beginning to see in passive investments like ETFs and index funds. They give you lower costs and also mirror macro market returns. The choice is yours; how you want to create a passive portfolio!
 
 

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