If you’re new to investing and have heard about passive funds, but aren’t sure what they are or how to get started, you’re in the right place. Passive funds are an increasingly popular choice for investors seeking a simple, low-cost way to invest in the stock market without the need for constant monitoring or stock picking.
In this guide, we will walk you through everything you need to know about passive investing, from what these funds are, how they work, to how you can invest in them.
We will also discuss the various types of passive funds, the benefits and risks associated with them, and some tips to get started.
What Are Passive Funds?
In simple terms, passive funds are investment funds that seek to replicate or “mirror” the performance of a market index rather than trying to beat it. This means that passive funds aim to match the performance of a specific market index, such as the Nifty 50 or Sensex in India, by investing in the same stocks that make up that index, in the same proportions.
Unlike active funds, where fund managers pick and choose stocks in an attempt to outperform the market, passive funds follow a “buy-and-hold” strategy, meaning they hold the same stocks as the index without frequent changes. This approach is much simpler and cheaper, making passive funds an attractive option for long-term investors.
How Do Passive Funds Work?
The concept behind passive funds is straightforward: they track the performance of an index by replicating its stock holdings.
For instance, if you invest in a Nifty 50 index fund, your investment will be spread across the same 50 companies that are part of the Nifty 50 index, and in the same proportions. So, if the Nifty 50 index rises or falls, your fund’s value will follow the same pattern.
There are two primary types of passive funds:
- Index Funds: These are mutual funds that are designed to replicate a specific market index like the Nifty 50, Sensex, or a sectoral index.
- Exchange-Traded Funds (ETFs): These funds work similarly to index funds but are traded on the stock exchange, like individual stocks. They offer greater flexibility since they can be bought and sold throughout the trading day.
Since passive funds just track the market, there is no need for active stock selection, which is why these funds usually have lower fees compared to actively managed funds. As a result, passive funds offer a more affordable way to invest, particularly for long-term investors who are not looking to constantly monitor their investments.
Types of Passive Funds
When it comes to passive investing, there are several types of funds available, each with its own features and benefits. Let’s look at the most popular types of passive funds available for Indian investors:
1. Exchange-Traded Funds (ETFs)
ETFs are a type of passive fund that are traded on the stock exchange like individual stocks. They typically track a market index or a sectoral index, giving you broad exposure to the market.
Advantages of ETFs:
- Liquidity: You can buy and sell Exchange-Traded Funds (ETFs) throughout the trading day, just like stocks.
- Flexibility: ETFs provide exposure to various asset classes such as equities, bonds, or even commodities.
- Cost-efficient: They tend to have lower expense ratios compared to actively managed funds.
Example: A Nifty 50 ETF tracks the performance of the Nifty 50 index, offering investors exposure to the top 50 companies listed on the National Stock Exchange (NSE) of India.
2. Index Funds
Index funds are mutual funds that seek to replicate the performance of a specific market index.
These funds are generally more suitable for investors who prefer a hands-off approach and want to invest in a diversified set of stocks that mirror a particular index.
Advantages of Index Funds:
- Diversification: Index funds invest in all the companies within a specific index, giving you automatic diversification across various sectors.
- Steady Growth: Since index funds follow the market, they typically provide steady growth in line with the overall economy.
Example: A Sensex index fund invests in the 30 largest companies listed on the Bombay Stock Exchange (BSE), mirroring the performance of the Sensex index.
Smart Beta Funds
Smart Beta Funds are a hybrid between active and passive funds. They use a rules-based approach to select stocks based on certain factors, such as value, momentum, or quality, rather than simply tracking a market-cap-weighted index.
Advantages of Smart Beta Funds:
- Risk-adjusted returns: They aim to deliver better returns for the same level of risk by focusing on factors like low volatility or high dividend yield.
- Better diversification: Unlike traditional index funds, smart beta funds may include stocks that are undervalued or that show higher growth potential.
Example: A Low Volatility Smart Beta Fund would invest in stocks that have lower price fluctuations, providing a safer option for risk-averse investors.
Funds of Funds (FoFs)
A Fund of Funds (FoF) is a type of passive fund that invests in other mutual funds rather than individual securities. This gives investors exposure to a diversified set of mutual funds, which can include both active and passive funds.
Advantages of FoFs:
- Further Diversification: Since FoFs invest in multiple funds, they provide diversification across asset classes, sectors, and even investment strategies.
- Convenience: FoFs simplify the investment process by providing exposure to a wide range of funds with minimal effort from the investor.
How to Invest in Passive Funds
Investing in passive funds is relatively simple. Here’s a step-by-step guide to get started:
Step 1: Open a Demat and Trading Account
To invest in passive funds like ETFs and index funds, you’ll need a Demat account and a Trading account. You can open these accounts with any broker or online investment platform.
Step 2: Choose the Right Fund
Before investing, you’ll need to choose which type of passive fund aligns with your financial goals. Some funds track broad market indices like Nifty or Sensex, while others may focus on specific sectors, themes, or asset classes.
Use tools to compare different passive funds based on their past performance, risk, and other important metrics.
Step 3: Decide Your Investment Method (SIP or Lumpsum)
If you prefer to invest regularly, you can set up a Systematic Investment Plan (SIP), where a fixed amount is invested at regular intervals (e.g., monthly or quarterly). If you have a lump sum amount to invest, you can make a one-time investment.
Step 4: Complete KYC (Know Your Customer) Process
To comply with regulatory requirements, you’ll need to complete the KYC process. This involves submitting documents like your PAN card, Aadhaar card, and bank account details.
Step 5: Start Investing
Once you’ve selected your fund and completed the KYC process, you can proceed with the investment.
Monitor your investments periodically, but remember that passive funds are designed for long-term growth, so frequent changes are not necessary.
Taxation on Passive Funds (2024-25)
Just like other mutual funds, passive funds are subject to taxation.
According to the Union Budget 2024-25, here’s how the tax on capital gains from passive funds works:
- Short-Term Capital Gains (STCG): If you sell the fund within 12 months of purchase, the gains are taxed at 20%.
- Long-Term Capital Gains (LTCG): If you hold the investment for over 12 months, the gains are taxed at 12.5%. The first Rs. 1.25 lakh of capital gains each year is tax-free, an increase from the previous Rs. 1 lakh.
Benefits of Passive Investing
Investing in passive funds has several key benefits, making it an attractive option for many investors:
- Lower Costs: Since passive funds don’t require active management, their fees are typically much lower compared to actively managed funds. This means you can keep more of your returns.
- Diversification: Passive funds typically track broad indices, offering exposure to a wide range of sectors and companies, reducing the risk associated with individual stocks.
- Simplicity: Passive investing is straightforward, just select the right fund and let it track the index.
- Steady Long-Term Growth: Over the long term, indices tend to grow in line with the economy, offering investors reliable returns.
Risks of Passive Investing
While passive funds have many benefits, they come with their own set of risks:
- No Potential for Out-performance: Since passive funds simply replicate an index, they cannot outperform the market.
- Market Downturns: When the market declines, your passive fund will also decline. Unlike active managers, passive funds cannot make adjustments during market downturns.
- Over-concentration: Many indices are weighted by market capitalization, which means larger companies have a bigger influence. This can result in over-concentration in a few large stocks.
Active vs. Passive Funds: A Quick Comparison
| Feature | Active Funds | Passive Funds |
| Management Style | Actively managed by fund manager | Follows a market index (passive) |
| Expense Ratio | Higher due to management costs | Lower, as no active management is required |
| Risk | Can outperform or under-perform the market | Matches market performance, less volatile |
| Returns | Potential for higher returns but also higher risk | Steady returns in line with the market |
Conclusion
In conclusion, passive funds are an excellent option for investors who are looking for a low-cost, diversified, and hands-off approach to investing.
By choosing a passive fund, you can benefit from long-term market growth without the complexity or high fees of actively managed funds. Whether you choose index funds, ETFs, or smart beta funds, passive investing provides a simple and effective way to build wealth over time.
As with any investment, it’s important to understand your financial goals, risk tolerance, and investment horizon before diving into passive funds. With the right strategy and patience, passive funds can be a valuable addition to your investment portfolio, providing steady growth over time.
