Passive funds are soaring in popularity in India. There has been a slew of launches of ETFs and index funds in the past few months.
The rising interest in passive investing is a result of the simplicity and low costs associated with such funds. The fact that actively-managed funds are increasingly failing to beat the indices is also one of the reason why passive funds are attracting interest.
The concept of passive investing may be simple but finding the best funds requires a little homework. Here are the steps you need to follow to make sure you are making the most out of passive investing.
Understanding investor's risk profile
Index funds may be less risky than actively-managed funds, but the volatility risk is still there.
The investor's risk profile is an important factor that helps determine which index fund to choose. Different index funds track different indices and hence carry various levels of risks.
One needs to assess his/her risk taking capacity and choose the passive fund accordingly.
The lower the tracking error, the better
Tracking error is the deviation of performance of the index fund from its target index.
One should select the ETF that has low tracking error. This is important to get the most efficient exposure to the index.
High tracking error reflects high transaction cost, extent of cash held and the expense ratio of the fund.
To maximise return, it is important to invest in ETFs with as low a tracking error as possible.
Look out for ETFs that are liquid
Evaluating the liquidity of ETFs is crucial to identifying the right fund. The liquidity of the fund determines how easily you can buy and sell the units.
Liquidity also affects the price at which the units can be bought or sold at the stock exchanges.
ETFs that are illiquid can create problems when one tries to sell them. Due to lack of demand, one may have to sell the units at a lower price than the prevailing NAV.
How to assess liquidity?
Investors can assess the liquidity of ETFs by looking at the divergence in the price and NAV. Higher divergence means low liquidity.
The other way is to look at the trading volume of ETFs. Low trading volume means low liquidity.
One should avoid ETFs that have negligible trading volume.
Periodic review
Like all investment instruments, passive funds too require periodic reviews to assess performance and suitability. This becomes necessary as the composition of indices change regularly, leading to a altering of the fund’s portfolio.
A change in composition necessitates the need to assess if the fund is still suitable for one’s requirements.
Moreover, passive funds see a change in liquidity and tracking error with time. During the review, investors need to evaluate if the liquidity and tracking error are still at the acceptable levels.
