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How to build a diversified portfolio with just passive mutual funds schemes?

Jagrity Sharma Jagrity Sharma 27 August 2019

Passive mutual funds are those funds that do not depend on the capabilities of the fund manager to choose the investments. They are easy to understand and follow a relatively safer approach to investing in broad segments of the market.

Passive Mutual Funds Schemes

Mutual funds have become relatively popular among Indian investors as an investment option in the past decade. Investing on a monthly basis in the form of SIP (Systematic Investment Plan) is more popular now than ever before.

While investing in mutual funds, either you can choose to be an active investor and expect higher returns than the market average, or you can choose to be happy with the returns that you can fetch as good as the stock market.

As the name suggests, an active mutual fund scheme involves a hands-on approach. The fund manager is expected to select the right security, at the right price and at the right time. The mutual fund portfolio comprises hand-picked investments. The primary idea here is to outperform the returns that the stock market gives.

However, active funds come with their own set of challenges. The higher fees and the possibility of underperformance due to decision of the fund manager may lead your portfolio not to earn the expected returns. The fund managers decide on which stocks and sectors to invest in. Though these funds have benchmark indices, they are not bound to outperform them. Some of the funds may even highly deviate from their benchmark indices.

Passive mutual fund investments help investors to earn in line with the market returns. The idea here is not to take additional risk and rather just be in line with the index that your passive mutual fund tracks. Moreover, there is no fund manager risk involved. Passive investing does not try to beat the market returns, but just tries to mirror the market. Hence, it helps you earn as good returns as the index.

One of the most successful investors, Warren Buffet once said, "Don't put, all of your eggs in one basket". It means you're putting every cent in one asset. If the value of your asset falls, then you are likely to lose all of your wealth. So, here comes the principle of diversification. However, forming a diversified mutual fund portfolio can sometimes be equally crucial and challenging as constructing a house. Portfolio diversification means investing your money in different asset classes. Hence, a breakdown in an asset or an economic slowdown affecting one of them will not adversely affect your entire investment portfolio. It is wise to invest in various asset classes, and funds to decrease overall investment risk. This helps you to avoid damaging your portfolio performance by the poor performance of a single asset or industry.

With around 150 passive funds and 4,000 actively managed funds listed by the Investment Association, it can be tricky to choose the best mutual funds in India. Investing in passive mutual funds is a low-cost strategy with an exposure of a given index or benchmark. Passive mutual funds have been around in the country for years. However, investors had limited choice till now. The existing passive mutual funds mostly come in the form of index-based offerings which somewhat restricts the utility of these funds. However, the situation has changed with several new passive mutual fund offerings targeting a much broader universe of stocks.

Now you can build a 100% passive portfolio covering a mix of the small or mid-cap. Large-cap and multi cap-oriented index funds or Exchange Traded Funds (ETFs). Depending on your risk profile, and the desired asset mix, you can invest money to a diversified passive mutual fund in different proportions. Apart from this, both gold and debt offer passive offerings, which allow you to diversify your passive mutual fund portfolio.

Moreover, if you seek sector-based exposure, you can invest in the banking sector ETFs. As more and more fund houses are introducing wide-ranging passive mutual funds, you will have multiple investment options to choose from.

However, the question is, should you go entirely passive? Actively managed funds charge relatively higher fees in the form of expense ratio for generating higher returns over the market index. The expense ratio and fees are justified as long as the fund manager is able to deliver expected returns consistently. However, the expense ratio starts to pinch when the returns are unfavourable.

Experts suggest that active funds offer better reward than passive funds, which is undoubtedly a fact. Unlike large-cap funds, returns remain healthy for mid-cap and small-cap funds. Mid-cap funds have successfully delivered 12.07% annualized returns over the last five years as compared to 11.1% of the BSE Mid cap TRI.

Below is the list of best mutual funds in India categorized as passive funds

  1. BIRLA Sun Life Index Fund
  2. DSP BlackRock Equal NIFTY50 Fund
  3. Franklin India Index Fund – NSE Nifty Plan
  4. HDFC Index Fund – Nifty Plan
  5. ICICI Prudential Nifty Index Fund

No investment is resistant to market-related risks and will most plausibly see some amount of fall at some point in time. Though in developed countries, passive mutual funds are popular, in emerging markets, including India, investors are in favour of active funds due to imperfect markets. As of today, you should not rely on the portfolio built up using truly diversified passive mutual funds.

It is advisable to include active mutual funds in your portfolio to take the exposure beyond frontline stocks. However, as technology catches up, the opportunities to outperform the market dry up, more and more investors are considering investing in passive funds. More extensive choice of passive funds will allow you to diversify your investment portfolio within the passive funds.

Recommended Read: Should You Invest in International Mutual Funds?

Jagrity Sharma
Written by Jagrity Sharma
A bibliophile who hates alliterations, but loves cream, comics and content immensely! On another note, a content marketer who leverages the power of words to explain...almost anything!