Passive Funds - Meaning, Types, Advantages and Disadvantages
What are Passive Funds?
It is a type of Investment Strategy in mutual funds that aims to mirror the performance of their underlying benchmark index, such as the Sensex or the Nifty. These funds invest in underlying instruments of the index they track and have fund managers to make sure that the fund constituents replicate the constituents of the index. [1] As of March 2024, passive funds account for about 17% of total MF AUM compared to about 7% five years ago.
Passive mutual funds endeavor to provide returns similar to that of their underlying index, except for some variation due to tracking error which may be because of the expense ratio and other factors concerning the scheme. It should be noted here that an Index is the first barometer we look at to understand how the stock markets have performed. Most of us may not remember the performance of individual stocks over various time periods but it is more likely that we will remember how an index has performed. For e.g. it is easier for most of us to recall what the Nifty 50 Index or Sensex was during March 2020 but the same may not be possible for all individual stocks part of the Nifty 50 Index.
Types of Passive Mutual Fund schemes:
- Index Funds: Index Funds are a category of mutual funds that aim to track the performance of a benchmark index. When Investor puts money in an index fund, the said amount will be then invested in all the companies that form part of a particular index which in turn may give the investor a diversified portfolio.
- ETFs - Exchange Traded Funds: ETFs are the funds that are traded on recognised stock exchanges, generally tracking a specific index. The investor investing in ETFs can buy or sell during the market hours at the prevailing NAV.
Both ETFs and Index funds invest a minimum 95% in securities of a particular index as defined in the respective scheme related documents.
Advantages of Passive Mutual Fund schemes:
Lower in cost:
ETFs and index funds have a lower expense ratio as compared to any active mutual fund scheme. The primary reason is that the portfolio is simply replicated from the chosen market index.
Reduced dependency on the fund manager to actively pick securities: Although fund managers of actively managed schemes make investment decisions on the basis of analysis, research and forecasts etc which are likely to return more than the benchmark index, sometimes this approach may not yield higher returns than the benchmark. Since an index fund replicates the market index, say Sensex, there is a reduced risk of such instances and the returns will be almost similar to the returns of the Index subject to the tracking error.
Exposure to the broad market:
Broad market Indices are diversified and represent the broader stock market. So, if you invest in a passive fund that tracks a broad market index, it will give you exposure to a vast range of stocks that may represent the market movement.
Easily understandable:
Since these funds closely replicate their underlying benchmarks, you can expect a return that is close to that of your fund's underlying benchmark subject to tracking error.
Disadvantages associated with investing in passive fund schemes:
Does not focus on outperforming the market:
There is no focus on earning higher returns than the benchmark index. Since the fund manager is bound to replicate the portfolio of the underlying benchmark index in the case of an index fund or an ETF, the investors may not get the possibility of earning higher returns than the underlying benchmark index.
Less flexibility:
The fund manager does not actively choose the instruments that have to be part of the underlying portfolio since the fund manager does not have the option to choose the securities that are not part of the underlying index.
Tracking error:
Tracking error is a very important factor when it comes to passive funds. These errors signify how closely a fund is tracking its underlying benchmark index. The higher the error, the greater the deviation between the fund’s performance and the performance of its underlying benchmark index.
How are passive funds taxed?
Given that these funds aim to replicate their underlying benchmark indices, their taxation will be based on the composition of their underlying indices.
For example, if a passive fund replicates an equity index, it will be taxed like any equity-oriented fund. On the other hand, if a passive fund replicates debt indices or gold, it will be taxed based on the respective asset class.
Introduction of Passive ELSS scheme in Index Funds
With a view of providing the benefits of passive investing along with tax saving options, SEBI through a circular on May 23rd, 2022 permitted the AMCs to offer passive ELSS mutual funds (through index funds) effective from 1st July 2022. In the case of an ELSS scheme, a lock-in period of 3 years exists.
At Zerodha Fund House, we offer a passive ELSS scheme viz., Zerodha ELSS Tax Saver Nifty LargeMidcap 250 Index Fund, the details of which can be found here.
Conclusion
Passive funds might be best suited for long-term investors looking for cost-effective exposure to the overall market. They could be a valuable addition to a diversified portfolio, but may not be optimal for investors seeking to consistently beat the market returns.
Source:
[1]: Passive Fund AUM contribution
Mutual Fund investments are subject to market risks, read all scheme related documents carefully
The Nifty and Sensex indices mentioned herein are owned by NSE Indices Limited and AIPL, a wholly owned subsidiary of BSE Limited respectively. All information provided is for informational purposes only
Please note that this article or document has been prepared on the basis of internal data/ publicly available information and other sources believed to be reliable. The information contained in this article or document is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party in any manner. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article or document.
Published on Sept 06, 2024
