What are Passive Funds?

Just as being passive in your daily life means that you are not actively taking action to shape your experiences or outcomes, investing in passive funds means that you are not actively managing your investments. Let's find out more about passive funds and the pros and cons of investing in them.

What is a passive fund?

A passive fund is a type of investment fund that follows a benchmark index and seeks to replicate its performance. It has a pre-determined portfolio of market securities. These funds can be categorised into index mutual funds or Exchange-Traded Funds (ETFs). Further, you can invest in passive equity funds and passive debt funds, depending on your investment goals.

Passive funds are becoming increasingly popular in India, as there has been a significant shift towards a low-cost, diversified investment model. Passive funds remove the need to actively monitor your portfolio while offering returns in line with the benchmark they follow. For busy investors, this has been a boon.

However, before you invest in passive funds, you must know the risks they entail.

What are the risks of passive funds?

As with all investments, passive funds carry some risk. Here are a few of them:

1. Market risk: Passive funds are exposed to market risk. If the underlying index or benchmark performs poorly, the passive fund will also perform poorly.
2. Portfolio concentration risk: Some passive funds may have a high concentration of a particular sector, industry, or company. If the performance of that sector, industry, or company declines, the fund may also suffer a significant decline in value. Therefore, it is crucial to invest in a passive fund with a diversified portfolio.
3. Tracking error risk: Tracking error risk refers to the possibility of the fund not generating returns in line with the index it follows. If the passive fund does not track the performance of the underlying benchmark effectively, its value may suffer.

The risks alone may not be conclusive, which is why it can help to go through the pros and cons of passive funds.

Advantages of passive funds

1. Lower fees: Passive funds typically have lower fees than actively managed funds since they require less management, research, and analysis.
2. Diversification: Passive funds can offer you a diversified portfolio of securities depending on the composition of the underlying market index.
3. Beginner-friendly: Passive funds are easy to understand and require little active management, making them a convenient investment option for most investors, especially beginners.

Disadvantages of passive funds

1. Limited growth: Passive funds aim to mimic the performance of the benchmark they follow and not outperform it. This may result in restricted growth.
2. Limited flexibility: Passive funds do not make active investment decisions based on market conditions and stay invested in the same securities as the underlying index. Hence, they may lose out on market opportunities.
3. Portfolio concentration: As mentioned earlier, if the fund has a high concentration of securities from a particular sector or industry, it can expose you to sector-specific market volatility and risk.

Investing in passive funds

While passive funds can be a great investment option for most investors, it is important to make investment decisions depending on your individual investment goals and risk tolerance. Having said that, they may be suitable for you if you prefer low-cost investing and are looking for a straightforward strategy without too much active management or intervention.

Conclusion

Passive funds can be an excellent investment option, but it is important to research and understand the fund you choose thoroughly. You must also carefully consider the advantages and disadvantages of passive funds or any other mutual funds before making any investment decisions.

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