Is passive investing the best way to grow wealth in the long term?

Ashutosh has always preferred investing in fixed income instruments. Over the next 10 years, he wants to save for his daughter’s higher education. He feels it is the right time to start investing in equity because of its high post-inflation returns.

However, what if the fund manager’s call of stock picks goes wrong? Ashutosh is wary of lagging fund performance. He has seen many instances of mutual funds delivering returns lower than the market index such as Nifty or Sensex. Is there a way he can avoid these risks?

Mutual fund investing is not only about a fund manager selecting stocks, creating a portfolio and then buying or selling stocks to manage the portfolio. Mutual funds come in two types—passively as well as actively managed funds.

Actively-managed funds is what we largely identify mutual funds with. They involve analysts and managers who try to hunt for ‘good quality’ stocks so as to generate a return which is in excess of a benchmark or an index. It seems Ashutosh is wary of this class of mutual funds.

As a novice investor who is wary of the risk of underperformance, Ashutosh could consider passive investing. A passive fund replicates the composition and performance of an index. For example, there may be an ETF or index fund on Nifty or Sensex, whose portfolio will be exactly the same as the index.

The fund simply buys and holds the stocks of Nifty or Sensex. Ashutosh will therefore, know what securities his fund holds, and he enjoys returns matching those of the index. Thus the performance of index scheme would rise or fall in accordance with the rise or fall in the target index. No more and no less.

Ashutosh might prefer the approach of a passive fund as it makes no attempt at forecasting and analysis of companies and stocks. Passive investing, therefore, serves his purpose of consciously avoiding the risks of active investing, where the returns will depend on the fund manager’s ability and timing to pick stocks/sectors. While it will provide equity-oriented returns using the index, there is no fund manager risk involved.

(The content on this page is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.)