What is passive investing and does it really work?

Active investing is all about taking a view on the markets and then taking a view on the stocks and buying stocks accordingly. Active investing can either be top-down or bottom, depending on which approach suits the situation better. The idea of active investing is to identify solid stocks that can create wealth in the long run and also beat the market index performance by a margin. Active investing combines stock selection and market timing to outperform the market. Stock selection is used to identify the stock while market timing using technicals is intended to get the best entry and exit in the market. The contrast to active investing is the passive investment, where you depend on the benchmark index to generate returns.

What is passive investing and does it make sense in India?

Passive investing is a different ball game. It is based on the premise that it is impossible to beat the market consistently. Remember, there are two challenges here. Firstly, it is based on the premise that fund managers will find it hard to beat the index as markets become more Mutual Funds Investments What is passive investing and does it really work?competitive and better researched. Then prices will reflect everything that has to be known about a stock. Secondly, it is hard to predict which fund managers will actually beat the index and you may end up with bad fund management decisions. Hence it makes more sense to just track the index over a period of time and get market returns. Buying an index fund or buying an index ETF are all examples of passive investing. The key argument in passive investing is that while there are some managers who will outperform on some occasions and some who will outperform on other occasions, it is impossible for an investor to know who will outperform and when. That is the reason passive investing makes a case for index investing. Don’t forget that the Sensex has multiplied 380 times since its inception in 1980. Surely, there has to be some merit in passive investing!

When passive investing can actually add value for investors…

More than seeing active investing and passive investing as competitive strategies, it is essential to understand when active investing works and when passive works better? Here are 5 key triggers when passive investing can actually add value…

  1. In the last 10 years since the financial crisis, global hedge fund managers have been finding it extremely difficult to beat the markets. When you find that the ratio of fund managers beating the index is falling, it is a signal to shift to passive investing. After all, why to pay those fancy fees to hedge fund managers when they cannot give that much sought after alpha.
  2. Is it a market that is driven by macros or by micros? An active approach is basically a stock selection approach and it works only when the micros trump the macros. When most markets were being driven by global systemic factors then passive funds will actually outperform active funds, net of all costs. That is again a case for passive shift.
  3. What you do when valuations are above historical averages. If the valuations are well above the historical average P/E and if there is limited earnings visibility, then again it is a case for passive investing over active investing. In such situations, stock selection is going to get awfully harder and you are better off keeping your equity exposures restricted to index funds. Costs will again matter in this case.
  4. Is the spread between active and passive fund returns consistently narrowing? If that spread is consistently narrowing then it means that active fund managers are increasingly finding it difficult to identify and play on alpha. In other words, active fund managers cannot compensate you sufficiently for the additional risk that you are being asked to take on. That is a clear indication for you to go ahead and shift to passive funds.
  5. Last but not the least, look at the cost differentials. In India, the difference is about 1.25%. Fortunately, most active funds have been able to generate much more than that so the active investing logic has held on. As an active investor, you always need compensation for the higher fees and the higher risk in the form of higher returns. Fees are a very important component of your total returns. You shift to passive investing like in the case of index funds and ETFs to save big time on fees over a period of time. Vanguard, which is a pioneer in index funds, has saved close to $1 trillion for investors over the years purely through lower fees. That explains why the two biggest fund houses in the world today(Blackrock and Vanguard) are passive funds; manage over $11 trillion between them.

There is surely merit in passive investing. You will be better off if you know when to shift to a passive approach to investing. At some point, the costs will just get too compelling for you!

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