Investors can eliminate price-NAV mismatch by opting for index funds

Long-term investors can optimise costs by purchasing ETFs through low-cost brokers

Passive investing appears to be gaining momentum. This is borne out by the National Stock Exchange’s (NSE) recent announcement that the assets under management (AUM) of passive funds which track the Nifty indices has surpassed Rs 5 lakh crore.

“Passive investing reduces non-systemic risk, which refers to stock selection and portfolio manager selection. These are risks over and above market risk, which may not necessarily result in a higher expected return over the index,” says Hemen Bhatia, head exchange-traded fund (ETF), Nippon Life India Asset Management.

Investors may go for ETFs or index funds when taking the passive route. Both mimic an underlying index. While an index fund can be purchased through a mutual fund distributor or from the fund house, ETFs have to be bought and sold on the exchanges.

When do index funds score?

Units of index funds are bought and sold at end-of-day net asset value (NAV). They offer investors assured liquidity.

The price of an ETF trading on a stock exchange can vary from the NAV. Says Shrinath ML, senior research analyst, FundsIndia: “This variation occurs due to the prevailing demand-supply situation. Sometimes, you may end up paying a higher price when buying and receive a lower price when selling.”

While index funds can be purchased using demat accounts or other means, a demat account is a must for trading in ETFs. Says Bhatia: “Index funds are preferred by investors who don’t want to operate through the broking-demat route.”

Systematic investment plans (SIPs) and systematic transfer plans (STPs) are available in index funds but not in ETFs.

When do ETFs work better?

ETFs typically have a lower expense ratio than index funds. For long-term investors with a buy-and-hold investment strategy involving large sums (using a low-cost broker), ETFs may prove more cost-effective.

ETFs are better suited for trading. Traders can seek to benefit from price fluctuations during the trading hours.

Before investing in an ETF, check how closely it tracks the real-time NAV. “Also evaluate its liquidity by looking at the daily traded volumes and bid-ask spread,” says Shrinath.

Go global via passive route

Passive funds are ideal for overseas investing. “Investors with a long-term view can capture the overall growth potential of international markets by adopting passive investing. It eliminates the need for frequent portfolio adjustments or market timing,” says Bharat Phatak, director, Scripbox.

Shrinath cautions that passive investing may not be the best approach for emerging economies. “Passive investing makes sense in developed, highly efficient markets such as the US, where most active funds underperform their benchmarks. But not many emerging markets are well developed and well tracked. Some carry regulatory and geopolitical risks, which would make passive investing too risky. Active funds are the preferred option in these markets,” he says.

Selecting the right passive fund

Before investing in a passive fund, check its expense ratio and tracking error. Lower values are better in both cases. Tracking error measures how closely the fund manager mimics the underlying index’s performance.

Bhatia offers a simple thumb rule for selecting the right ETF: the acronym VICTER [V = volume (higher the better); IC = impact cost (lower the better); T = tracking error (lower the better); and ER = expense ratio (lower the better)].

All ETFs belonging to a specific category are not similar. One may think that all Nifty50 based ETFs would be the same because they hold the same 50 stocks in their portfolios. “The VICTER test can help investors identify the right ETF benchmarked to a particular index,” says Bhatia.

Constructing a passive portfolio

Passive funds are a good option for beginners who may find it difficult to select an active fund. “A simple Nifty50 index fund is a good starting point for a conservative investor. Investors willing to take higher risks can consider a mix of large-cap (Nifty50 or Nifty 100) and mid-cap (Nifty Midcap 150) index funds. An investor with a moderate risk profile should limit mid-cap exposure to 30 per cent, while a more aggressive investor can go up to 50 per cent,” says Shrinath M.