Passive mutual funds: Meaning, types and how they work

• Table of contents

• What are passive mutual funds?
• How does passive funds work?
• Types of passive funds
• Factors to Consider Before Investing in a Passive Fund
• How to strategise your approach to investing in passive fund
• Things to know about passive mutual funds

What are passive mutual funds?

A passive fund is a type of mutual fund that tracks market indices like Nifty or S&P BSE Sensex. The fund portfolio mirrors the index it is based on. Such funds typically seek to replicate the performance of the market (subject to a tracking error, which is the difference between the fund’s performance and that of its benchmark index).

This passive approach usually implies lower costs, because such funds do not involve frequent trading, and fund managers are not tasked with stock selection or management. This can make passive funds offer a cost-effective way to diversify investments.

How do passive funds work?

Passive mutual funds, including index funds and exchange-traded funds (ETFs), are designed to mirror the performance of a specific market index such as the Nifty 50 or the BSE Sensex. Unlike actively managed funds, which rely on fund managers to pick securities, passive funds replicate the index’s composition. This results in relatively lower expense ratios.

Here’s how they generally function:

• Index tracking: The fund manager builds a portfolio that mirrors the holdings of the selected index.
• Minimal intervention: Changes in holdings occur only when the index itself is rebalanced.
• Lower costs: The passive management style usually results in relatively lower expense ratios compared to actively managed funds.

Passive funds offer a way to invest in a diversified portfolio that reflects the movements of a specific market segment. While they do not aim to outperform the benchmark, they are structured to provide returns that closely match the index (subject to tracking error). This can make them slightly less risky than active mutual funds as there is no fund manager bias. However, this also means that unlike active mutual funds, such funds do not seek to outperform their benchmark in the long term.

Types of passive funds

Each type of passive mutual fund is designed to cater to different investment strategies and preferences. Some broad passive mutual fund types include:

• Index fund: These funds track the performance of a particular stock market index, like the Nifty or the Sensex. The portfolio comprises the same stocks in the same proportion as the index.
• Exchange-traded funds (ETFs): ETFs also track an index but are traded like stocks on the stock exchange. They can be bought and sold at market prices throughout the trading day.
• Smart beta funds: The fund portfolio mirrors that of strategy indices. Those indices choose stocks based on certain factors or characteristics such as value, quality, or momentum, rather than company size. Examples of strategy indices include Nifty Quality Low Volatility 30, Nifty200 Momentum 30 Index and Nifty200 Value 30.
• Fund of Funds (FoFs): These funds invest in other mutual funds or ETFs, providing a way to gain exposure across various asset classes through a single investment.

Also Read: What are the benefits of investing in mutual funds?

Factors to consider before investing in a passive fund

Before investing in a passive fund, it is important to consider the following factors:

• Define your goals: Identify your financial goals to pick the passive mutual fund that is suited to your needs. For instance, if you are saving for retirement, a home purchase, or another goal that is five-to-seven years away or more, equity-oriented passive funds may be better suited. These offer the potential to build wealth over time but can be volatile in the short term. Debt-oriented funds may be better suited for short-term goals, where relative stability of the invested capital is important.
• Diversify your investments: Spread your money across different assets and regions using ETFs, index funds, and more, to reduce risk and aim for better long-term returns.
• Assess your risk tolerance: Choose funds that match how much risk you can handle. By doing that, you are better able to deal with the ups and downs of the market.
• Think long-term: Short-term market fluctuations typically do not have a significant impact on your investments when you have a long investment horizon.
• Monitor and adjust: Regularly check your investments to ensure they are in line with your goals. Rebalance if needed to maintain your risk and diversification levels.

How to strategise your approach to investing in passive funds

Building a strategy for investing in passive funds in India requires considering financial goals, risk tolerance, and investment duration. Here’s a framework to help develop a structured approach:

• Define your objectives: Identify your financial goals, whether for retirement planning, wealth accumulation, or short-term targets.
• Assess your risk tolerance: Understand how comfortable you are with market fluctuations, as passive funds are still subject to market risks.
• Choose the right index: Select indices that align with your investment needs. There are different indices based on market caps, investment strategy, asset class, sector exposure etc.
• Diversify across asset classes: You may consider using passive funds to spread investments across equity, debt, or international indices, depending on your risk appetite.
• Consider expense ratios: Since costs impact net potential returns over time, paying attention to expense ratios can be beneficial.

Things to know about passive mutual funds

Here are some features and benefits of passive mutual funds:

• Cost-effectiveness: Passive funds typically have lower expense ratios than active funds because the fund manager has a relatively limited role in portfolio design and management.
• Market tracking: These funds aim to replicate the performance of a specific index. The investment performance, therefore, is aligned with broader market trends. This can be suitable for investors who want to mitigate the impact of a fund manager’s decision-making on their investment.
• Risk management: Diversification across multiple securities helps spread risk.
• Simplicity: They offer a straightforward investment approach, suitable for investors who prefer a hands-off investment strategy.

Considerations:

Investors should consider their investing objectives, risk tolerance, and preferences when deciding between passive and active funds. Mutual funds can captivate investors seeking active management and the prospect of outperformance, while passive funds are tailor-made for those pursuing broad market exposure at lower costs. Within a diverse investment portfolio, each choice has a different function.

Also Read: What are hybrid funds?

Conclusion

Passive mutual funds provide a cost-effective and simple way to invest in the market. By tracking established indices, these funds offer diversified exposure. Their transparency and relatively lower expense ratios make them a suitable choice for investors looking to align their portfolio’s performance with broader market movements.

FAQs

What are passive mutual funds, and how do they work?

Passive mutual funds follow a market index, such as the Nifty 50 or BSE Sensex. They aim to mirror the index’s performance by holding the same securities in the same proportion. Since they do not involve active management, they generally have lower expense ratios.

How do passive funds differ from active funds?

Passive funds replicate an index, whereas active funds aim to outperform the market in the long term through strategic stock selection and active portfolio management.

Are passive funds better than active?

Neither passive nor active funds are inherently better. Passive funds tend to have lower costs and aim to match market performance. Active funds strive for higher returns but come with increased risk and expenses. The choice depends on investment goals and risk appetite.

Difference between passive and active funds?

Passive funds aim to match market returns by tracking an index and typically have lower costs. Active funds, on the other hand, seek to outperform the market through strategic investments, which may result in higher potential returns in the long term but also come with higher fees and risks.

Which is the best passive fund?

The most suitable passive fund depends on your financial goals and risk tolerance. Key factors to evaluate include tracking error, expense ratio, and the index being followed.

Are passive funds good?

Passive funds can be suitable for investors looking for lower-cost options that align with market performance. They provide diversification and transparency by following an index. However, they do not aim to outperform the market, so their suitability depends on individual investment objectives.

How can I strategise my investment approach with passive funds?

Align passive fund investments with your long-term financial objectives. Use index funds or ETFs to achieve diversification across market segments. Invest across asset classes to balance risk and return potential. Carefully select the index that you wish to invest in, as the composition of the index (large cap, mid cap, small cap etc) will influence the risk-return profile.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.