Simplicity is the USP of passive funds. Clubbed with other advantages like low cost and transparency, passive funds have emerged as one of the leading investment options in the recent times.
But they are not yet perfect. There are certain barriers to investing in passive funds that have prevented some section of investors from jumping on the bandwagon.
Let’s take a look at these factors:
Liquidity concerns
If an ETF is thinly traded, investors could face problems in getting out of the investment. Though market makers are there to prevent such issues from arising, they themselves avoid taking positions in ETFs that are not in demand.
This is the concern that dissuades many investors from investing in ETFs.=
But there's a solution to it. A little bit research can help investors identify illiquid ETFs. The biggest sign of an illiquid investment is large spreads between the bid and ask. Investors should track the spreads and the market movements for at least a week before investing.
The other way around is to invest in index funds. As these funds are bought and sold through the company, the liquidity risks are negligible.=
Lack of flexibility
What is the biggest fear of investors when it comes to investing in market-linked instruments? Most investors would say a market crash due to an unexpected event.
While active funds have strategies in place to minimise the impact of any such event, passive funds do not have the flexibility to come up with an action plan.
This lack of flexibility has a bearing on investment decisions in regular days as well. Passive funds have no option but to 'blindly' follow the indices without considering the worthiness of the underlying investments.
This can be a cause of concern for some investors.
Need for a demat account
Demat account is a necessity for investing in ETFs. But everyone does not have it. People who are not into trading stocks do not see any purpose in opening a demat account.
This reflects in data as well. As of 2020-end, there were only 44.46 million demat accounts in India, according to SEBI. Considering India's population of 1.36 billion, the penetration of demat accounts is a mere 3.2%.
However, this ratio is on the rise as technology and advent of cheap trading apps has reduced the entry barrier. This trend is likely to continue in the near future.
Barriers not big enough
Like every investment instrument, passive funds have their own flaws. But the advantages outweigh the shortcomings. This is the reason why there is a massive rise in interest in passive funds.
Moreover, some of these barriers are fast disappearing. Demat accounts are reaching more and more Indians and liquidity concerns are vanishing with the rise in trading of ETFs.
