What are Passive Funds & How to Invest in Them?
Passive mutual funds have become a popular choice for investors seeking steady growth with minimal active management. In India, these funds have attracted attention due to their low cost and low maintenance approach. As more investors shift towards passive strategies, understanding the basics of these funds is crucial. This blog will explore the meaning of passive funds, types of passive funds, and strategies for passive investments.
What is a Passive Fund?
Passive mutual funds mirror the performance of a market index, like Nifty or Sensex, aiming to match its returns. The portfolio of a passive fund is structured to replicate the index’s composition and proportions, eliminating the need for active stock selection by the fund manager. This simplicity makes passive funds more accessible and easier to monitor compared to active funds.
Investors choose passive funds to align their returns with the broader market, benefiting from their cost-effectiveness. These funds have lower management fees since they don’t involve extensive research, stock selection, or frequent trading. This cost efficiency adds to their appeal as a straightforward and economical investment option.
In India, passive funds provide cost-effective, diversified exposure to the market with minimal management and tracking error. As awareness of passive investing grows, more investors appreciate the advantages of these funds, including lower costs, diversification, and alignment with long-term market trends.
How do Passive Funds Work?
Passive investing involves mirroring a market index by holding the same stocks in the same proportions as the index. For instance, a Nifty 50 index fund will include the same companies as the Nifty 50 index. The objective is to match the market’s performance rather than outperform it, so when the market rises or falls, your investment does the same.
In the case of commodities, such as gold, a gold ETF invests in physical gold bars with 99.5% purity, tracking the price of gold directly. Since passive funds simply follow the market, they require minimal management, which keeps costs lower than actively managed funds.
In summary, passive funds can provide a simple, low-cost way to invest by mirroring the market, making them an easy-to-understand option for many investors seeking a straightforward approach.
Types of Passive Funds
As India’s financial landscape evolves, passive mutual funds continue to attract both novice and seasoned investors. These funds come in several forms, each with distinct features and goals.
ETFs (Exchange-Traded Funds)
ETFs are a popular type of passive fund, merging the benefits of stocks and mutual funds. Traded on stock exchanges, ETFs offer investors exposure to a range of assets, such as equities, bonds, and commodities, by tracking an underlying index. Like stocks, they can be bought and sold throughout the trading day, providing flexibility and liquidity. Investing in ETFs requires a Demat account for transactions.
Index Funds
Index funds are designed to mirror the performance of a specific market index. They build their portfolios by investing in the same securities and proportions as the chosen index. Rather than trying to outperform the market, index funds aim to match the benchmark’s performance, offering a straightforward way for passive investors to gain broad market or sector exposure.
Smart Beta Funds
Smart Beta funds combine elements of both active and passive mutual funds management. Using a rules-based strategy, these funds consider factors like value, quality, or momentum to create portfolios that differ from traditional market-cap-weighted indexes. The goal is to achieve better risk-adjusted returns than the benchmark while maintaining the cost-efficiency typical of passive investing.
Fund of Funds (FoFs)
A Fund of Funds (FoF) is a unique passive investment vehicle that invests in multiple mutual funds rather than individual securities. By pooling funds from various sources, an FoF achieves diversification across different asset classes, sectors, and markets. The fund manager selects and manages passive funds that suit the investor’s risk profile, which can come from the same or different fund houses. FoFs offer an efficient way to diversify portfolios and manage risk.
How to Invest in Passive Funds?
Investing in passive mutual funds can be a straightforward process. Here’s a guide to get you started:
- Open a demat/trading/brokerage account. Investors can open a demat account with smallcase!
- Register online at any AMC website.
- Explore different passive funds, including the different types of passive funds, to figure out which one suits your investment objectives.
- Investors can use tools like the Tickertape Mutual Fund Screener to sort through these passive funds and explore their fundamentals and performance in the past. They can sort through the 200+ filters available to track fund performance.
- Proceed to invest by clicking on the appropriate option and specifying the amount and investment mode (SIP or Lumpsum).
- Submit your KYC details, including your PAN number and bank details, to finalise your investment.
Note: It is important to conduct thorough research and consult a financial advisor before investing in anything.
Overview of Passive Funds in India
The passive investment strategy in India has evolved significantly over the past 25 years. What started with Nifty and Sensex index funds in the late 1990s has now expanded to include a wide range of index funds and ETFs across various market capitalisations. Today, passive funds cover different investment factors like momentum, value, quality, and growth, as well as sectoral funds.
Many fund houses now offer passive funds that track foreign indices, and even the fixed income segment has seen the introduction of passive options in Government Securities and liquid funds. In the commodities market, gold and silver passive funds are also available.
While institutional investors like pension funds, insurance companies, and corporate treasuries still dominate passive funds, these investment options are gradually gaining traction among retail investors in India.
Taxation on Passive Funds as per the Union Budget 2024-25
Passive funds are usually taxed as equity funds. Understanding the latest tax regulations on equity mutual funds is essential for making informed investment decisions regarding passive investment funds. The Union Budget 2024 has introduced significant changes to the taxation of equity mutual funds, simplifying the tax structure while altering rates and benefits. Here is a detailed breakdown of the new tax rules:
Short-Term Capital Gains (STCG)
If you hold equity mutual funds for less than a year, the gains from these investments are classified as short-term capital gains. According to the new budget, these gains are now taxed at a rate of 20%, which has been increased from the previous rate of 15%.
Long-Term Capital Gains (LTCG)
For equity mutual funds held for more than a year, the gains are considered long-term capital gains. The key points to note under the new budget are:
- Tax-Free Limit: Gains up to Rs. 1.25 lakh in a financial year remain tax-free. This limit has been increased from the previous threshold of Rs. 1 lakh.
- Tax Rate: Any gains above Rs. 1.25 lakh are taxed at a flat rate of 12.5%. It was previously taxed at 10%.
- Indexation: It’s important to note that the benefit of indexation, which previously allowed investors to adjust the purchase price of their assets for inflation, has been removed for all asset classes, including equity mutual funds.
Indexation is a method used to adjust the purchase price of an asset (like property or gold) for inflation over the years. This adjusted price is then used to calculate capital gains. Previously, long-term capital gains from selling property, gold, or other unlisted assets were taxed at 20%, but you could use indexation to reduce your taxable profit. The new rule simplifies the tax structure by setting a flat 12.5% tax rate for all long-term capital gains. However, it removes the indexation benefit.
Summary
| Capital Gains Tax | Holding Period | Old Rate | New Rate |
| Short-Term Capital Gains (STCG) | Less than 12 months | 15% | 20% |
| Long-Term Capital Gains (LTCG) | More than 12 months | 10% | 12.50% |
- No Indexation Benefit: This change affects the overall tax liability, potentially increasing it for long-term investors.
Difference Between Active and Passive Funds
Here is a table of comparison between active and passive funds:
| Aspect | Active Funds | Passive Funds |
| Nature | Dynamic and flexible, adapting to market conditions and opportunities. | Static and rigid, following a predetermined passive strategy that mirrors an index. |
| Expense Ratio | Higher, due to fund manager’s research, analysis, and trading efforts. | Lower, reflecting a simplified strategy with minimal management involvement. |
| Risk | Higher, influenced by the fund manager’s skill, judgment, and potential errors. | Lower, as they closely follow an index, reducing volatility and tracking error. |
| Returns | Aims to outperform the benchmark index, but may occasionally underperform. | Provides returns closely aligned with the benchmark, offering market-aligned returns. |
Strategies for Investment in Passive Funds
When planning an investment strategy for passively managed funds, it’s essential to align your approach with your financial goals, risk appetite, and investment horizon. Here’s a concise guide to help you craft an effective plan:
- Investment Objectives: Investors can start by defining their financial goals, such as saving for retirement, funding education, or building wealth. Clear objectives can help you choose the right mix of passive funds that suit your needs.
- Diversification: Diversification is vital in reducing risk. You can allocate your investments across different asset classes, sectors, and regions. Investors can consider a mix of ETFs, Index Funds, Smart Beta Funds, and Funds of Funds to spread risk and potentially improve returns.
- Risk Tolerance: Understanding your comfort level with market volatility can be helpful. You can then select funds that match your risk tolerance to ensure that your investments align with your financial objectives.
- Long-Term Focus: Passive index investing can work best over a long-term investment period. Investors can maintain a long-term perspective, allowing their investments to avoid short-term market fluctuations.
- Monitor and Rebalance: Investors can regularly review their portfolio to ensure it stays aligned with their goals and risk tolerance. You can rebalance as needed to maintain your desired asset allocation and diversification.
Benefits and Risks of Passive Investing
Benefits of Passive Investing
Here are a few potential benefits of passive investing:
- Cost-Efficient: Passive investing typically incurs lower transaction costs due to less frequent trading. Additionally, management fees for index funds or ETFs are usually lower than those for actively managed funds.
- Diversification: Investing in index funds and ETFs offers exposure to a broad range of companies, which helps spread risk compared to investing in individual stocks.
- Performance: Many passive strategies have been shown to perform as well as, if not better than, active strategies over time.
- Transparency: With passive investing, you clearly know the assets you own since they mirror a market index.
- Simplicity: This approach is straightforward and easier to manage, making it especially suitable for novice investors.
Risks of Passive Investing
- No Market Beating: Passive investing is designed to match market returns, not exceed them, meaning you forego the chance to outperform the market.
- Lack of Flexibility: Even the best passive index funds in India must adhere to their strategy, even during market downturns, limiting flexibility in adverse conditions.
- Risk of Overexposure: If an index is heavily weighted towards certain sectors or companies, your exposure to these areas may be higher than desired.
- Limited Potential for Gain: The buy-and-hold strategy inherent in passive investing might miss out on short-term profit opportunities.
- Influence of Market Cap: In many index funds, larger companies have a greater impact on performance due to market cap weighing, which may reduce the influence of smaller, potentially high-growth companies on your returns.
Factors to Consider When Investing in Passive Funds
Here are a few factors to consider when investing in passive funds:
Investment Strategy
Passive mutual funds primarily follow a “buy and hold” strategy. Fund managers replicate the composition of a benchmark index, making minimal portfolio adjustments, which reduces costs compared to actively managed funds. These funds may track broad market or sector indices to optimise outcomes. When selecting passive funds, it’s crucial to consider your financial goals, risk tolerance, and time horizon.
Risk
While passive mutual funds, like all market-linked investments, come with inherent risks, they generally pose lower risks than actively managed funds. By mirroring a market index, these funds invest in a diverse range of securities, providing a degree of stability. For long-term investors, passive funds can deliver returns aligned with the benchmark, with less volatility. It is important to evaluate your risk tolerance and ensure it aligns with your chosen funds.
Returns
Passive mutual funds aim to replicate the performance of their benchmark index, such as the Sensex or Nifty. The portfolio structure and stock allocation closely match the index, resulting in returns that typically mirror market performance. While they don’t aim to outperform the index like active funds, passive funds focus on delivering benchmark returns with minimal variation.
To Wrap It Up…
In conclusion, the rise of Passive mutual funds in India reflects a growing awareness of their advantages, particularly their low-cost, index-tracking nature. Passive funds, which replicate the performance of benchmark indices, allow investors to benefit from market growth without the need for active stock selection or frequent trading.
Understanding the different types of Passive funds—such as ETFs, Index Funds, Smart Beta Funds, and Funds of Funds—can help investors make informed decisions and build a diversified portfolio. By aligning these investments with their financial goals, risk tolerance, and investment horizon, investors can effectively utilise the benefits of passive investing.
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Frequently Asked Questions About Passive Funds
Passive funds offer a way to manage investment risk, though they still face market risks. These funds follow a set index based on predefined rules, reducing the risks of selecting individual stocks or portfolio managers. However, they mirror the index’s fluctuations and may concentrate on a limited range of sectors or stocks. Poor performance in these areas can lead to a decline in the overall value of the investment portfolio.
Passive funds can attract investors seeking steady growth with minimal management. They can also suit investors who are looking for a straightforward approach to investing.
Passive funds generally have lower expense ratios, which can enhance investor returns. They follow a long-term investment approach, avoiding the costs and performance limitations associated with frequent trading.
Checking the fund’s facts or the management company’s website can reveal if the fund is passive. Ultra-low fees often suggest passive management, while higher fees can typically suggest active management.
A fund becomes passive when it seeks to replicate the performance of a specific market index or sector rather than trying to outperform it. Unlike active funds, which involve a portfolio manager choosing individual stocks, passive funds aim for simplicity and accessibility.
