Passive Mutual Funds

Passive investing is increasingly viewed as an interesting option in an ever-dynamic environment. The financial markets can be quite volatile and, at times, unpredictable. Simple and relatively inexpensive, passive mutual funds provide an avenue to tap market growth without the active management and related expenses common in many traditional funds. These mutual funds track certain market indices. By mirroring the performance of such benchmarks, these funds provide broad market exposure, thereby reducing the risk associated with individual stock selection.

In this comprehensive guide, we go in-depth into passive mutual funds in India, weighing the pros and cons and how they can suit your investment strategy.

What Are Passive Funds?

Passive funds, as the name suggests, are passively managed and strive to mimic the performance of a particular index, such as the S&P BSE 500 or Nifty 50. They hold a fixed portfolio of stocks per the index's composition.

Passive funds are cheap and straightforward, but they do not have the flexibility of an actively managed fund. As the awareness of passive investing increases, Indian investors, too, have started liking the benefits that come with passive funds in the form of lower cost, diversification, and alignment with long-term market trends.

Types Of Passive Funds

The different types of passive funds are given below:

Overview Of Passive Funds In India

Passive investing in India has undergone a sea of change over the last two and a half decades from only two index funds, Nifty and Sensex, being launched in the late 90s to today, when index funds and ETFs are tracking across market capitalisations, various investment factors like momentum, value, quality, and growth, and sector funds.

Internationally, several fund houses offer passive funds exposure to various international indices. On the fixed-income side, passive funds have also been launched in segments relating to G-Secs and liquid funds. In commodities, there are passive funds for gold and silver, among others.

Institutional investors-through pension funds, insurance companies, and corporate treasuries-continue to dominate the passive fund space. These funds are slowly making their presence felt among retail investors.

Pros And Cons Of Passive Funds

Understanding Active Funds Vs Passive Funds

Active funds are investment funds wherein the manager actively selects securities to buy, retain, or sell so that the fund may perform better than the market. The best-case scenario desired is a return in excess of what the benchmark index can provide. Research, analysis, and strategic changes are crucial for a fund manager. These offer more significant return opportunities but are considerably riskier due to extensive buying and selling and calls on market timing.

A comparison of active and passive funds is drawn to help understand some of the key differences between them:

Why Passive Funds Are Right For You?

Data from the Association of Mutual Funds in India (AMFI) shows that 106 different new fund offers, or NFOs, were launched by various mutual fund houses in the first seven months of 2024. Of these new schemes introduced, 63 passive schemes were launched in just seven months, against 51 passive schemes launched in the previous year.

The choice of passive funds is not highly relevant compared to the choice of active funds. For example, the best-performing active large-cap fund over a five-year term is at 19% CAGR, while the worst has been at 14% CAGR. All 50 Nifty ETFs over a comparable period have returned something around 15% CAGR, with minor differences in returns.

Here is why passive funds can be the right investment for you:

• No human bias - While many investors try to achieve the best returns from the market, making money out of volatile assets like stocks is tricky. Passive investing simplifies this by avoiding the pursuit of a fund manager trying to beat the market. A passive fund tries to keep the same makeup in a benchmark index, which returns the same as the index's.
  
• Simplicity - Passive investments are simpler to manage and track than actively managed ones. Fund managers follow the underlying index and rebalance the portfolio only when it changes based on a well-prescribed transparent methodology.
  
• Return - In a growing economy like India, equities do well over the long term. Broad-based indices capture this growth, thus making passive funds a simple way to participate in the economy's upward trajectory.
  
• Cost-efficiency - For instance, actively managed equity funds can charge as much as 225 basis points for management, while investing in index funds may charge as much as 100 basis points. For ETFs tracking broad indices such as the Nifty 50, this cost can fall to as low as 5 basis points. That said, investors would do well to consider aspects such as trading volume in the ETF, impact cost, tracking error, and expense ratio. A no-frills, low-cost fund with minimal tracking error thus stands to offer better cost savings over time.
  
• Diversification - Most of the mutual funds that are passively managed are inherently diversified. The broad-based indices have a large basket of stocks that ensure no single stock takes precedence over and above the returns in a portfolio.

Taxation Of Passive Funds

Passive equity funds are taxed the same as active equity funds or equity shares. The short-term capital gain is taxed at a uniform rate of 15%. If you sell your passive equity fund units after a holding period of at least a year, you will trigger long-term capital gains. The latter is exempt from tax for up to ₹1 lakh per year. All long-term capital gains exceeding this limit are taxed at 10% without any indexation benefit.

Top Passive Funds With A History Of Exceptional Returns

Listed below are some of the passive funds that have generated excellent returns in the last three years:

Things To Remember Before Investing In Passive Funds

Passive funds are ideal for new investors who want to experience growth parallel to the indices. Some key points to remember are:

• Ensure that the ETF tracks the returns of the underlying index closely. If an index has generated 10% returns historically, the investor in this ETF would rightfully expect approximately 10% returns from his fund. The metric that may capture this replication is called 'Tracking Error', defined as a measure of the closeness of ETF performance to the index. The lower the value of this tracking error, the more desirable the investment outcome.
  
• Apart from tracking errors, the expense ratio accompanying the ETF is what the investors should analyse. Generally, a low expense ratio is considered good for investors, as it may affect the overall return.
  
• Liquidity is also one of the key parameters based on which the ETF should be judged. Generally, the ETFs based on market capitalisation indices such as Nifty and Midcap are popular and have higher trading volumes. This liquidity, therefore, provides a ready counterpart for the ETF buy and sell process through an exchange. Heavy trading in an ETF keeps prices near quotations on the exchanges, and the trading experience becomes hassle-free.
  
• An ETF investor must be aware of the total cost of ownership, including AMC charges, demat charges, and brokerage. In the case of index funds, there is a consolidated cost of ownership whereby an investor pays only the total expense ratio.
  
• Taxation rules remain the same for all passive equity funds, active equity funds, and equity shares. If an asset sold within a year from the date of purchase, it attracts short-term capital gains. On the other hand, if passive equity fund units are sold after holding the units for one year, long-term capital gains would arise.

Conclusion

Passive mutual funds have gained immense popularity in the Indian investment scenario. It is an offering that presents investors with a straightforward, less expensive, and diversified way of investing. Tracking specific indices, these funds give broad exposure to securities to cut risks associated with selecting individual stocks.

Passive funds have been one of the popular vehicles for Indian investors seeking long-term returns due to their relatively lower expense ratio and tax efficiency. It is, however, essential that an investment decision be made with careful consideration of investment goals, risk tolerance, and passive fund characteristics.
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