Most mutual fund schemes that we are aware of are actively managed by fund managers. Take a look at the image below.
Today, I want to talk to you about mutual funds that are not actively managed. These are alternatives to active mutual funds. The portfolio selected for these funds are selected based on a set of rules. Investing is automated to some extent. The idea of passive funds is that they help avoid human bias, by setting down the rules of investing. But is there more to them? Let’s dive deeper.
Index Fund
Index funds are mutual funds that follow a particular index. In India, Sensex and Nifty are the two most well-known indices. If we take Nifty, it is a combination of 50 companies from different sectors that gives a representation of the entire economy. Now, if you wish to invest directly into these 50 companies, you may require a large capital. With a smaller capital, you could invest in a Nifty Index Fund instead. This fund is offered by various mutual fund houses. It will have the same portfolio as Nifty, and will only change when there are changes in the index. Thus, an index fund doesn’t need an active manager.
ETF
Exchange-traded Funds or ETFs are investment vehicles similar to index mutual funds, but traded on the stock exchange. In simple words, these are index mutual funds available as stocks. Since they are on the stock exchange, the prices are real time, and the units come into the demat account.
Nifty BeEs (Benchmark Exchange-Traded Scheme) was the first ETF launched in 2002. Five years later, Gold ETFs were launched. Sector-specific ETFs have also become popular over the years. Last year, Edelweiss introduced the first ever debt ETF – the Bharat Bond ETF.
ETFs are comparatively cheaper than index funds.
FOF
A Fund of Fund is a Mutual fund which typically invests in other mutual funds. Unlike a portfolio of shares, an FOF is a portfolio of one or more mutual funds. These mutual funds can be within the same fund house or in others. The portfolios of many FOFs also consist of ETFs. This helps investors, who don’t have a demat account, gain exposure to ETFs. Similarly, there are also specific FOFs that invest in international funds.
It is pertinent to note that all FOFs are taxed as debt mutual funds, irrespective of the portfolio. (We’ll be discussing more on taxation of mutual funds in next week’s newsletter)
Quant funds
Quant funds are a type of mutual that use quantitative methods to build and manage the portfolio. They use a set of algorithms to invest instead of a human handling it. And although there are many opportunities with the advancements in AI and big data, there are many risks associated with these funds. Since the algorithms are based on historical records, it assumes that the past will repeat itself, which is almost never the case.
Note: Quant funds are not to be confused with similar-sounding Asset Management Companies – Quant Mutual Fund and Quantum Mutual Fund.
Are these alternatives worth investing in?
Having understood the various alternatives to active mutual funds, you might wonder which one to invest in; all or none?
While Index funds, ETFs and FOFs are good investments in general, I would suggest not giving in to the hype around them. You may have an index fund in your portfolio, but it need not comprise your entire portfolio. And you should consider a gold ETF only if you want to add gold to your portfolio, not because ETFs are less expensive.
Of the four alternatives I’ve touched upon above, Quant funds are the only ones that can be avoided.
Ultimately, your investment choices should be made based on your asset allocation strategy, your goals and their time horizons, and your risk appetite.
