PASSIVE FUNDS: GROWTH, ADVANTAGES, AND COMPARISON WITH ACTIVE FUNDS

WHAT ARE PASSIVE FUNDS?

Passive funds are mutual fund schemes that aim to replicate the performance of a benchmark index such as the Nifty 50 or Sensex. Instead of trying to outperform the market, these funds invest in the same securities and in the same proportion as the underlying index.

Passive funds include:

• Index Funds
• Exchange Traded Funds (ETFs)
• Fund of Funds (FoFs) investing in ETFs

The objective of passive investing is to deliver returns that closely match the benchmark index, subject to factors such as expense ratio and tracking error.

Unlike actively managed funds, passive funds follow a rule-based investment approach with minimal intervention from the fund manager. The fund manager primarily ensures that the portfolio mirrors the benchmark index accurately.

As of March 2024, passive funds accounted for nearly 17% of the total mutual fund Assets Under Management (AUM) in India, up from approximately 7% five years ago, highlighting the growing popularity of passive investing among investors.

Passive investing has also gained strong traction among retail investors. According to the third edition of Motilal Oswal Mutual Fund’s Passive Survey 2025, nearly 68% of Indian retail investors now invest in at least one passive fund.

Why are Indices Important?

Indices such as the Nifty 50 and Sensex act as key indicators of stock market performance. Investors often remember how an index has performed over time more easily than the performance of individual stocks.

For example, many investors may recall the level of the Nifty 50 during March 2020, even if they do not remember the performance of every stock within the index.

WHAT ARE ACTIVE FUNDS?

Active funds are managed by professional fund managers who actively participate in investment decisions such as buying, selling, and portfolio allocation.

Fund managers conduct market research, economic analysis, and company evaluations to identify investment opportunities and attempt to outperform the benchmark index. Unlike passive funds, active funds rely heavily on the expertise and judgment of the fund manager.

PASSIVE FUNDS VS ACTIVE FUNDS

TYPES OF PASSIVE MUTUAL FUND SCHEMES

1. Index Funds

Index funds are mutual funds that track a specific benchmark index. The investor’s money is invested in all the companies forming part of that index, thereby providing diversification.

2. Exchange Traded Funds (ETFs)

ETFs are market-traded investment funds that generally track a specific index. They can be bought and sold on stock exchanges during market hours at real-time prices.

Both ETFs and Index Funds typically invest at least 95% of their assets in securities forming part of the underlying index.

ADVANTAGES OF PASSIVE FUNDS

Lower Cost: Passive funds usually have lower expense ratios because the portfolio simply replicates the benchmark index and does not require active management.

Reduced Dependence on Fund Manager: Since passive funds follow an index-based strategy, their performance is less dependent on the fund manager’s stock-picking ability.

Diversification and Broad Market Exposure: Broad market indices represent multiple sectors and companies, providing diversified exposure to the overall market.

Transparency and Simplicity: Passive funds are relatively easy to understand because their performance closely mirrors the benchmark index, subject to tracking error.

Liquidity in ETFs: ETFs can be bought and sold on stock exchanges during market hours, offering liquidity similar to stocks.

DISADVANTAGES OF PASSIVE FUNDS

No Objective to Outperform the Market: Passive funds aim only to match the benchmark and do not attempt to generate returns higher than the index.

Limited Flexibility: Fund managers cannot actively exclude underperforming stocks or include opportunities outside the benchmark index.

Tracking Error: Tracking error measures the deviation between the fund’s returns and the benchmark’s returns. A higher tracking error indicates weaker replication efficiency.

TAXATION OF PASSIVE FUNDS

The taxation of passive funds depends on the composition of the underlying benchmark index.

• Passive funds tracking equity indices are taxed like equity-oriented mutual funds.
• Passive funds tracking debt or gold indices are taxed according to the taxation rules applicable to those respective asset classes.

PASSIVE ELSS FUNDS

To combine the benefits of passive investing with tax savings, SEBI permitted Asset Management Companies (AMCs) to launch passive ELSS schemes through index funds via a circular dated May 23, 2022, effective from July 1, 2022.

Like traditional ELSS funds, passive ELSS schemes come with a mandatory lock-in period of three years.

ACTIVE FUNDS VS PASSIVE FUNDS: WHICH SHOULD YOU CHOOSE?

The choice between active and passive funds depends on an investor’s financial goals, investment horizon, and risk appetite.

• Investors seeking low-cost, diversified market exposure may prefer passive funds.
• Investors aiming for benchmark-beating returns and willing to take relatively higher risk may consider active funds.

A balanced combination of both active and passive funds can also help achieve diversification within an investment portfolio.

CONCLUSION

Passive funds have become increasingly popular because they offer low-cost, diversified, and transparent investment opportunities by tracking benchmark indices. While active funds aim to outperform the market through expert management, passive funds focus on stable market-linked returns with lower risk and expenses. However, the choice between active and passive funds depends on an investor’s financial goals, risk appetite, and investment strategy.