BackLow-effort wins: This is how passive investing can outperform frequent trading
Passive ETFs and index funds consistently outperform active fund managers due to lower expense ratios and stable returns, driving a surge in passive investments in India.
PremiumPassive ETFs/Index funds outperform the majority of active fund managers. How many times have we read this headline! By now, even the most rookie investor understands that active managers who run a high expense ratio face an uphill battle in beating their benchmark indices on a net return basis.
India’s growth story has been much talked about and has captivated the investing community for several years. It has been a story of resilience as well, given how the economy and the stock markets kept on going, while the world was dealing with an almost out of control inflation. All through this, the Nifty index has delivered a return of close to 27% for FY24.
With the stock market growing rapidly, investments in funds that passively replicate index returns have also gone up significantly. As per data available from AMFI, the ETF/Index funds in India have seen their AUM go up by approximately ₹250,000 crores or roughly 39% growth from the start of the current financial year. A large draw for investors towards passive funds is lower cost/expense ratios for most such funds. The expense ratios can be as low as 1/4th of comparable active funds, while still delivering the returns of an index.
In contrast, active funds typically aim to surpass benchmark indices such as Nifty 50 or BSE 500 trillion. However, looking at the returns of large-cap-focused mutual funds with active portfolio management, only a handful have managed to consistently outperform the Nifty 50 trillion benchmark over a 3 to 5 years horizon. Further, most such actively managed funds exhibit higher volatility in their returns compared to indices.
For an individual investor looking for investment opportunities, passive investments either in index ETFs or specific stocks based on sound research may provide better returns compared to actively managing their portfolios. Investors evaluating a large number of companies cannot do justice to the diligence required for each stock. Instead, they can focus their available time and resources on examining a handful of companies with long term growth prospects.
Passive investments also help in avoiding many of the pitfalls of active investors, such as biases in favour/against a sector/industry/company; turning risk averse or cavalier based on their investments history; relying on ‘tips’/inputs of others without doing their own research and the worst possible pitfall of all, FOMO!
Apart from the above, there are a few more key elements to consider while evaluating passive investing against an active management of the portfolio.
1. Taxes: Holding onto investments for longer will reduce the tax to LTCG rates, as against STCG rates. Currently the base LTCG rate is 10%, compared to a STCG base rate of 15%.
2. Transaction costs: There are transaction costs involved each time an investor buys or sells a stock, mutual fund, or even trades in derivatives. These include SEBI Turnover fees, stamp duty, GST, Security Transaction Tax (STT), etc. Over and above, the investors will also end up paying brokerage. While a single instance of these charges may not dent the overall returns, these charges can add up significantly if the transactions are frequent.
3. Time value of taxes/charges: Passive investments held for a long duration will not be subject to taxes till the time capital gains are realised. By deferring tax payments and not incurring transaction costs regularly, a larger capital base is allowed to grow and can add a little more to overall returns.
Having said all this, it is important to understand why people like to invest in actively managed funds. The answer is simple, people don’t like being average. They are happy to take the risk of mostly being below average to avoid being average because there is a small chance they will be above average.
As counterintuitive as this sounds, this is how human psychology works; and coming to think of it, what is the stock exchange if not the best barometer of human mood?
Let us say you have invested in a passive fund and your returns are exactly the same as that of the market, how are you going to be the cool person at the party or the ace in the golf course conversation on investments. There will always be that one person who would have done better. This is one of the main reasons why investors avoid passive investing.
There are ways in which one can have the cake and eat it too. Unfortunately, this option is currently restricted only to High Net Worth Individuals who can invest in Cat III AIFs with a minimum ticket size of 1cr.
Puneet Sharma, CEO, and Fund Manager at Whitespace Alpha
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