What exactly are passive funds?
Simply put, passive funds, primarily index funds and Exchange Traded Funds (ETFs), aim to replicate the performance of a specific market index, like the Nifty50 or the Sensex. “Instead of a fund manager actively picking stocks, passive funds buy the same stocks in the same proportions as the index they track. This “fill it, shut it, and forget it” approach has profound implications on returns,” says Atul Shinghal, founder and CEO, Scripbox.
Look at the compelling case for passive investing in India
1. Lower costs, higher returns: This is arguably the biggest differentiator. Passive funds have significantly lower Expense Ratios (ERs) compared to actively managed funds. An active fund might charge 1.5% to 2.5% annually, while a passive index fund typically charges 0.1% to 0.5%. Over the decades, this seemingly small difference can compound dramatically. Every rupee saved in fees is a rupee earned for you.
“Through passive funds you get an exposure to a particular index at low cost. This way, you do not pay for fund manager led active stock selection. While cost advantage remains, there have been phases and parts of markets where active fund management & stock selection have generated superior returns outperforming benchmark. Also, there are gaps in the passive offerings like lack of hybrid funds. Make a choice based on the type of portfolio you want to build, or even better, benefit from both,” said Amol Joshi, Founder, PlanRupee Investment Services.
Consider this: If two funds generate 12% gross returns each, but one charges 2% and the other 0.2%, your net return difference is a significant 1.8% per year. Over 20 years, this can mean tens of lakhs of rupees more in your pocket.
2. Outperformance challenge for active funds: Globally, and increasingly in India, many active funds struggle to consistently beat their benchmark indices over the long term, especially after factoring in their fees. “Experience from developed markets suggests that sustaining it over 5, 10, or 15 years is incredibly difficult. By investing in an index fund, you are guaranteeing yourself market returns, minus a minuscule fee,” said Shinghal.
3. Simplicity and transparency: Passive funds are easy to understand. You know exactly what stocks you own because they mirror the index. “There’s no black box, no reliance on individual fund manager brilliance (or lack thereof). This transparency fosters confidence and reduces the need for constant monitoring,” said Shinghal.
4. Broad diversification: Investing in a Nifty50 index fund, for instance, gives you instant exposure to 50 of India’s largest and most liquid companies across various sectors. This inherent diversification significantly reduces the risk of a single stock performing poorly.
5. No fund manager risk: Fund managers can change, their investment philosophies can shift, or they might simply have a bad run. With passive funds, your returns are tied to the market, not an individual’s performance. This removes a layer of uncertainty and risk from your portfolio.
Making passive funds your portfolio’s anchor
For most Indian investors, especially those with a long-term horizon (5+ years), passive equity funds can form the foundational layer of their portfolio. “You can then consider allocating a smaller portion to actively managed funds for specific themes or sectors where you believe a skilled manager can genuinely add alpha (e.g., small-cap, sectoral, thematic funds),” says Shinghal.
While cost-effective and simple, passive investing foregoes market outperformance (alpha), as it merely tracks an index, unlike skilled active managers who can beat the market. Passive funds offer no flexibility during downturns, fully absorbing market crashes without defensive measures. They also carry concentration risk in cap-weighted indices, over-exposing investors to potentially overvalued large stocks. Furthermore, passive funds lack qualitative filters, buying all index components irrespective of their fundamentals, and are susceptible to tracking error. Essentially, passive investing surrenders control and adaptive capabilities.
Start with widely recognised indices such as the Nifty50, Sensex or Nifty Next 50. These capture the essence of large-cap India Inc. As you grow, you might explore mid-cap or sectoral index funds/ETFs, but with caution and within your core passive allocation.
True wealth accumulation often lies in embracing simplicity and cost-effectiveness. By making passive funds a core part of your investment strategy, you’re not settling; you’re making a savvy, long-term decision.
