What is Passive Mutual Fund? Meaning, Types & How to Invest

What Are Passive Mutual Funds?

Passive mutual funds are investment schemes that seek to generate returns by tracking the performance of a specific benchmark index, such as the Nifty 50, Sensex, Nifty Next 50, or other market indices. Rather than selecting stocks based on market research or fund manager expertise, the fund invests in the same securities as the underlying index in nearly the same proportion.

The performance of the fund would then mimic the performance of the index, although there may be slight differences due to the cost factor or any other market condition.
 

How Do Passive Mutual Funds Work?

Passive mutual funds pool funds from several investors and replicate the composition of the defined index as accurately as possible. Whenever the index changes, the composition of the fund is adjusted to follow the same index.

For example, consider a passive mutual fund tracking the Nifty 50 Index. If the index allocates approximately 10% to Company A, 8% to Company B, and 6% to Company C, the fund maintains similar allocations. If Company D replaces one of the stocks in the index, the fund also updates its portfolio to reflect that change.

Portfolio adjustment is less common in such cases because of the lack of involvement of market forecasting in investment decision-making.

Benefits of Passive Mutual Funds

• Some of the key advantages of passive mutual funds include:
• Lower expense ratios because they require less active management.
• Broad market diversification through a single investment.
• Transparent portfolio as the underlying index is publicly available.
• Reduced fund manager bias since investments follow a predefined methodology.
• Suitable for long-term wealth creation through disciplined investing.
• Can be invested through lump sum investments or SIPs.

Disadvantages of Passive Mutual Funds

• While passive funds offer several advantages, they also have certain limitations:
• They cannot outperform the benchmark index.
• Returns move with market performance, including market declines.
• Tracking errors may lead to slight differences from index returns.
• Limited flexibility during changing market conditions.
• Investors remain exposed to sectors that carry higher weights in the benchmark.
   

Types of Passive Funds

Passive investing can be done through different categories of mutual funds, each designed to meet varying investment preferences.

Index Funds

An index fund is an open-ended mutual fund that copies a market index, such as the Nifty 50 Index, Sensex, Nifty Midcap 150, and any other market benchmark indices.

The investments are made at the net asset value (NAV) of the fund after the market closes for the day. Investors don't require a demat account to invest in index funds because they can buy and sell their units through the mutual fund itself.

Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETFs) mimic market indices, but unlike index funds, they are traded on the stock exchange just like stocks.

ETF prices fluctuate throughout the trading day depending upon the market demand and supply. The investor needs to have a demat and trading account in order to buy or sell ETF units.

Examples of ETFs may include Nifty 50, Sensex, Gold ETF, Government Securities ETF, and others.

Fund of Funds (FoFs)

A fund of funds is one where the money is invested into one or many mutual funds, rather than being invested in stocks or bonds directly. In case of passive investing, FoFs usually invest in domestic or foreign index funds or ETFs.
 

Tracking Error in Passive Funds

Tracking error measures the difference between a passive fund's returns and the returns of the benchmark index it seeks to replicate.

A lower tracking error generally indicates that the fund is closely following its benchmark.

Some common reasons for tracking error include:

• Fund management expenses
• Cash held for liquidity requirements
• Timing differences while rebalancing the portfolio
• Transaction costs
• Corporate actions such as dividends or mergers

For example, if the benchmark index delivers a return of 12% during a year and the passive fund generates 11.7%, the difference of 0.3% represents the tracking difference for that period.

When deciding to invest in a passive fund, it is important to analyse its past performance and select funds with consistently lower tracking errors.
 

Taxability of Passive Funds

Due to their primary investment in equity shares or equity benchmark indices, equity passive mutual funds are taxed as equity mutual funds.

• Short-Term Capital Gains (STCG): Investors' gains are subject to applicable equity mutual fund tax laws if they sell units within a year.
• Long-Term Capital Gains (LTCG): Long-term capital gains are subject to the current Income Tax Act rules if investors retain units for longer than a year.

Example

Suppose an investor purchases units of a passive mutual fund worth ₹2,00,000 and sells them after two years for ₹2,70,000.

Purchase Value: ₹ 2,00,000

Sale Price: ₹ 2,70,000

Capital gain Rs.70,000

The profit of ₹70,000 is considered long-term capital gain due to the investment being kept for longer than a year. At the time of redemption, the total tax liability will be calculated using the current equity mutual fund tax legislation.    
 

What Should Be Your Investment Strategy in Passive Funds?

Consider the following strategy when investing in passive mutual funds:

Step 1: Understand the Purpose of Financial Goals

Firstly, determine your personal goals whether it can be a fund for retirement, education, or any other purpose. Determination of financial goals will help in identifying the appropriate funds.

Step 2: Consider Portfolio Diversification

Diversification is one of the most essential parameters for creating an investment portfolio. Diversification can be done by using index funds, ETFs, Smart Beta, or even Fund of Funds. Portfolio diversification helps in spreading market risk as well as helps in growing the investment funds in the long run.

Step 3: Know About the Risk Level of the Investments

Know your own risk level before opting for schemes as there are some indices which can have market variations whereas broad market indices offer stable growth in terms of returns. Choosing funds according to the risk level will be better to handle market variations.

Step 4: Stay Invested for the Long Run

Passive investments are usually made to create wealth in the long run. Staying invested over different market cycles can allow investors to take advantage of the growth of the entire index as opposed to reacting to short-term volatility.

Step 5: Periodical Review of the Portfolio

Although passive investments require less management than active investments, it is important to periodically review the portfolio to make sure that your investments are still aligned with your objectives.

You can invest in passive mutual funds through the 5paisa platform by exploring available schemes, comparing funds, and investing online based on your financial requirements.
 

How to Choose the Right Passive Fund

Factors to consider before investing in passive mutual funds include:

1. Assess the Tracking Error: Check the fund's tracking error and select a scheme with consistently lower deviations from the benchmark index.

2. Compare Expense Ratio and Costs: Like all mutual funds, passive funds come with costs so your investment is well managed. Lower cost ratios help offset a higher net income.

3. Review Assets Under Management (AUM): Larger funds often offer better operational efficiency and better liquidity for investors.

4. Align with Your Financial Goals: Make sure the benchmark index tracked by the fund complements your individual goals and risk appetite.

5. Analyse Past Performance: When deciding to invest in a passive fund, it is important to analyse its past performance and consistency across market cycles.
 

Who Should Make an Investment in Passive Mutual Funds?

Depending on their investing requirements and financial objectives, passive mutual funds may be appropriate for a variety of clients:

• Long-Term Investors: For steady long-term growth, investors who intend to build wealth over several years may choose to look into passive mutual funds.
• First-Time Investors: Because funds follow a predefined index rather than complex stock-picking, those making their first investments may like them.
• Moderate Risk Investors: To gain exposure to established market benchmarks, investors who are at ease with moderate market risk may select passive funds.
• Goal-Based Investors: These funds may be included in the investment portfolio of people who are saving for retirement, further education, or other long-term objectives.
• SIP Investors: Regular investors can progressively increase their wealth over time by using Systematic Investment Plans (SIPs).
• Portfolio Diversifiers: Investors looking to balance their equity investments may add index funds for greater portfolio stability.
   

Passive Mutual Funds vs Active Mutual Funds

The following table explains the difference between a passive fund vs active fund.

Conclusion

Passive funds are often opted for by investors, particularly beginners, seeking consistent market returns with low management costs. Success in passive mutual funds depends on the scope of your investment and the period. It is suggested to go for a long-term investment, at least 5-7 years. Investors looking for potential market-beating returns through active stock selection should go for actively managed funds.