What are Passive Index Funds and How Do You Invest in Them?

Passive funds offer investors, especially beginners, a convenient and relatively cost-effective way to participate in the financial markets. Passive funds follow a passive investment strategy, where they aim to replicate the performance of a stock market index (subject to tracking error, which is the difference between the performance of the fund and the benchmark index).

The portfolio of a passive fund mirrors that of the benchmark index, comprising of the same securities in the same weightage. There are two main categories of passive funds in India: index funds and Exchange Traded Funds (ETFs).

This article tells you more about passive funds to help you decide if such a fund could be suitable for you.

• Table of contents

1. What are passive funds?
2. Aligning investment goals with passive funds
3. Types of passive funds
4. How to choose a suitable passive index fund

What are passive funds?

In a passive fund, the fund manager plays a passive role in portfolio selection and management. Index funds and exchange-traded funds or ETFs are two common types of passive funds.

Such funds aim to replicate the performance of a specific market index, such as the Nifty 50 or the BSE Sensex, subject to tracking error. The portfolios of these funds are designed such that they have a proportionate representation of the basket of securities in that index. Such funds can provide investors with broad market exposure at a relatively lower cost compared to actively managed funds.

Aligning investment goals with passive funds

Before investing in passive funds – whether an index fund or an ETF – it is important to ensure that it aligns with your investment risk appetite, investment horizon, and financial objectives. An equity index fund or ETF will typically be high-risk, while a debt index fund or ETF may entail moderate risk

An allocation to passive funds as part of a diversified portfolio can be considered by:

• Investors who seek diversification across sectors and asset classes with a single investment may consider passive index funds.
• New investors who are seeking simplicity and convenience.
• Cost-sensitive investors may consider passive index funds due to the relatively lower expense ratios than actively managed mutual funds.
• Investors who prefer an index-linked portfolio to one that relies on a fund manager’s decision-making.

Types of passive funds

There are two broad types of passive funds:

Index Funds Index funds track and seek to replicate the performance of a specific index, such as the Nifty 50 or BSE Sensex (subject to tracking error). They invest in the same securities as the index in the same proportions, providing broad market exposure. Within index funds, there are several types, depending on the underlying benchmark index. These includes large cap indices, mid cap indices, multi-cap indices, debt indices etc.

Exchange-Traded Funds ETFs are similar to index funds but are traded on stock exchanges like shares. They offer flexibility to buy and sell during market hours and track various indices, commodities, or sectors.

How to Choose a Suitable Passive Index Fund

Choosing a suitable passive index fund depends on various factors, such as your investment goals, risk tolerance, and investment horizon. Here are some tips to help you choose the right index fund:

• Understand different indices: There are various types of index funds, such as broad-based funds, sector-specific funds, and factor-based funds. Broad-based funds invest in a wide range of stocks across different sectors, while sector-specific funds invest in a specific sector, such as technology or healthcare. Within broad-based funds too, there are large-cap, mid-cap, small-cap and other options. There are also various stock indices to choose from, including Nifty, S&P BSE Sensex and CRISIL. Factor-based funds invest in stocks with specific characteristics, such as value or momentum.
• Fund performance: Look at the fund’s tracking error, a measure of how closely the fund’s performance correlates with that of its underlying index. A higher tracking error indicates greater deviation from the index, while a lower tracking error indicates closer alignment to index performance.
• Check the fund’s expense ratio: The expense ratio is the annual fee charged by the asset management company for managing the fund. Passive index funds typically have lower expense ratios than actively managed funds.
• Define your investment objectives: Determine your risk tolerance, investment horizon, and financial goals. This will help you select an index fund that aligns with your specific requirements.

FAQs:

What are passive index funds?

Passive index funds are mutual funds that track a specific market index, such as the S&P 500 or Nifty 50. The fund’s portfolio replicates that index, and the returns are based on the performance of that index, subject to tracking error.

Are passive index funds suitable for all investors?

Passive equity index funds are suitable for investors who want to invest for the long-term, have high risk tolerance, are looking for a relatively low-cost investment strategy and prefer a passively managed fund. However, it's essential to evaluate one’s investment goals and risk tolerance before investing. It is also advisable to consult a financial advisor before making investment decisions.

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 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