Why Passive Funds Should Be a Core Part of an Investor's Portfolio?

In an investment approach, the portfolio is divided into two distinct components: a core portfolio and a satellite portfolio. The primary objective of your core portfolio will be to achieve long-term financial goals and provide long-term growth potential through diversification & stability. A satellite portfolio is a smaller, more flexible portion of the portfolio that allows one to take advantage of high-growth opportunities but may also have relatively higher volatility associated with it. The allocation between core and satellite will strictly depend on the investors' risk appetite, individual financial goals, and investment horizon.

Passive funds are often recommended as a core part of portfolio for several reasons, due to their features like low cost structure, diversification, transparency, consistent market return, absence of Fund Manager bias, no unsystematic risk and long-term suitability.

Let's examine the USP's of passive funds in detail

Low-Cost Structure: Passive funds don't require active management, so they have a significantly low expense ratio, and this can lead to higher returns over the long term. (e.g. the expense ratio of Kotak Nifty ETF is 0.04 per cent)

Diversification: Passive funds tracks broad market index and provides instant diversification across many stocks and sectors. This reduces the concentration risk. (e.g. Kotak MSCI India ETF gives exposure to 158 large Indian companies.)

Transparency: Passive funds are transparent, as they mirror the performance of specific index which makes easy to understand what you're getting, where the money is invested and how the fund is performing. Also, passive funds openly disclosing their underlying holdings, tracking error, and expense ratios which helps to understand how it performs against its benchmark.

Consistent Market Returns: Passive funds objective is to track and mirror the performance of underlying index and keeps you invested through ups and downs. So, in long term it often delivers more predictable returns and steady growth.

Absence of Fund Manager Bias: Passive funds do not aim to outperform the benchmark and stick to their index regardless of market conditions, they are structured to provide returns that closely match the index. As the fund replicate the index so there is no fund manager bias in stock selection.

No unsystematic risk: Passive investing helps the investors to eliminate unsystematic risk from the investment portfolio and provides a cost-effective way of investing. (e.g. risks such as selecting a wrong company for investments or investing in a company at higher valuations etc. can be avoided in passive investing).

Long-term suitability: Passive funds invest in a broad range of market sectors and companies and offer the potential for long-term capital appreciation. It helps to fulfil long-term goals like buying a house, children's marriage/education, retirement, etc.

One can construct a core portfolio with passive funds by investing in broad market equity ETFs or index funds along with some portion of investment through tactical allocation in thematic and smart beta passive funds, which can help to produce alpha in overall portfolio in long term. For asset allocation purposes, one can also invest in fixed-income ETFs/Index Funds and commodity ETFs/FOFs (e.g. those investing in precious metals such as gold or silver).

Overall, passive funds provide broad market exposure at a low cost with less hassle, making them an excellent foundation for a long-term diversified portfolio. For investors who are looking for index-based investment solutions, ETFs & Index Funds provide an affordable way for investors to gain broad market exposure. Look for a fund house offering cost-effective passive investment options with low expense ratios and efficient tracking of benchmarks to minimise costs without compromising on performance.

(The author is Fund Manager, Kotak Mahindra AMC)

(Disclaimer: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.)