Passive Funds

Passive funds are investment vehicles designed to replicate the performance of a market index rather than outperform it. Also known as "tracker" funds, they provide investors with access to the markets they track at a lower cost compared to active funds. Examples of passive funds include index funds and exchange-traded funds (ETFs).
EXPLORE FUNDS
What are Passive Mutual Funds
EXPLORE FUNDS
4 mins read
10-September-2024

Passive mutual funds, as a long-term investment strategy, prioritise maximising the returns by minimising frequent buying and selling. Unlike active investing, which aims to outperform the market, passive investing involves holding a diversified mix of assets that mirrors specific market segments. The most common approach is investing in index funds, which provide a valuable addition to your investment portfolio. This article will explain about passive funds and how they serve as a valuable addition to your investment portfolio.

What are passive funds?

Passive mutual funds consistently mirror the performance of a market index to maximise returns. The portfolio of a passive fund precisely replicates a designated market index, such as Nifty or Sensex, with the composition and proportion of investments matching the tracked index.

In contrast to active funds, passive funds operate without the need for the fund manager to actively select individual stocks. This simplicity makes passive funds more accessible and easier to monitor compared to their active counterparts. Investors opt for passive funds to align their returns with overall market performance. The cost-effectiveness of these funds is notable as they do not incur expenses associated with stock selection, research, or frequent trading of securities. This cost efficiency contributes to the appeal of passive funds as an uncomplicated and economical investment option.

How does passive funds work?

Passive investing revolves around choosing a market index and forming its replica by investing in the same stocks in a similar proportion as done by the index. After that, the fund starts tracking the index closely and making changes to the portfolio as per the underlying index to make the fund closely identical to the index. When it comes to passive funds, there is no process related to selecting stocks, as the stocks of these funds are like that of their underlying indices. Therefore, fund managers play a limited and passive role, which is the ultimate meaning of passive funds.

Types of passive funds

There are several types of passive mutual funds for investors to build wealth over time. Here are some of the most popular ones:

  1. Index funds: Index funds are mutual funds or exchange-traded funds (ETFs) that track a specific market index, such as Sensex or Nifty. They are designed to replicate the performance of the index they track and offer investors broad exposure to a particular segment of the financial market.
  2. Exchange Traded Funds (ETFs): ETFs are a type of passive fund that tracks the performance of an underlying index. An ETF is a portfolio that closely resembles an index. ETFs don’t try to outperform their benchmark indexes. Furthermore, ETFs trade on the stock exchange, and thus one can buy and sell ETFs on the exchange. As a result, the ETF prices fluctuate throughout the day.
  3. Fund of Funds (FOFs): FOFs are mutual funds that invest in other mutual funds. They are designed to provide investors with a diversified portfolio of funds. FOFs can be actively or passively managed.
  4. Smart beta: Smart beta funds are similar to ETFs in many ways. They combine the benefits of passive funds with the selection of active investments based on certain criteria. This allows the fund to generate higher returns using a cost-effective model.

On one hand, smart beta funds follow the underlying index when it comes to performance. On the other hand, they make changes to their portfolios based on market movements. Like ETFs, smart beta funds lack fund manager bias.

How to strategise your approach to investing in passive funds

Here are the key points to consider when strategising for passively managed funds:

1. Identify objectives:

  • Determine your financial goals (e.g., retirement, education funding, wealth accumulation).
  • Clear objectives guide your choice of passive funds.

2. Diversify your portfolio:

  • Spread risk by allocating investments across asset classes, sectors, and regions.
  • Consider ETFs, Index Funds, Smart Beta Funds, and Funds of Funds.

3. Assess risk tolerance:

  • Understand your comfort level with volatility.
  • Choose funds aligned with your risk appetite.

4. Long-term focus:

  • Patience is key for passive investing.
  • Short-term market fluctuations matter less over time.

5. Monitor and rebalance:

  • Regularly review your portfolio.
  • Adjust asset allocation as needed to maintain diversification and risk exposure.

Pros and cons of passive investing

Like any investment strategy, investing in passive mutual funds has its benefits and disadvantages. Here is a quick look at both:

Pros

Cons

Low expense ratio

Limited flexibility

Diversification

No opportunity for outsized returns

Easy execution

No protection against market downturns


How to invest in passive funds with Bajaj Finserv?

Investing in passive funds is relatively easy on the Bajaj Finserv platform. Just select the mutual fund scheme you want to invest in and follow these steps:

  • Step 1: Click on INVEST NOW. You will be redirected to the mutual funds listing page.
  • Step 2: Filter by scheme type, risk appetite, returns, etc. or choose from the top performing funds list.
  • Step 3: All the mutual funds of the particular category will be listed, along with the minimum investment amount, annualised return, and rating.
  • Step 4: Get started by entering your mobile number and sign in using the OTP.
  • Step 5: Verify your details using your PAN, date of birth.
    If your KYC is not complete, then you will have to upload your address proof and record a video.
  • Step 6: Enter your bank account details.
  • Step 7: Upload your signature and provide some additional details to continue.
  • Step 8: Choose and select the mutual fund that you want to invest in.
  • Step 9: Choose whether you want to invest as SIP or lumpsum and enter the investment amount. Click on ‘Invest Now’
  • Step 10: Select your payment mode i.e., net banking, UPI, NEFT/ RTGS
  • Step 11: Once your payment is done, the investment will be complete

Your investment will start reflecting in your portfolio within 2-3 working days.

Conclusion

Passive investing, a long-term strategy, aims to maximise returns by minimising frequent buying and selling. Unlike active investing, which seeks to outperform the market, passive investing involves holding a diversified mix of assets that mirrors specific market segments.

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Frequently asked questions

Why is passive investing better for investment returns?

Passive investing, often through passive mutual funds, is a strategy that aims to maximise returns by minimising buying and selling. It’s considered better for investment returns due to its lower costs and simplicity. Passive funds typically have lower expense ratios, which can lead to better returns for investors. Moreover, passive investing is a long-term strategy that avoids the fees and limited performance that may occur with frequent trading.

Is passive investing a bubble?

Whether passive investing is a bubble is a topic of debate. Some believe that the inflated price of stocks due to high levels of passive investment into index funds distorts the true market value. However, others argue that the current situation cannot be described as a “passive investing bubble” as they believe a high price to earnings ratio is mainly driven by bullish market sentiment rather than inflows to passive funds.

Are passive investments secure?

While no investment can guarantee absolute safety, passive investments are generally considered more secure compared to actively managed ones. By mirroring a benchmark index, passive funds diversify investments, enhancing stability and risk distribution. Passive funds typically entail lower risk levels than actively managed counterparts, appealing to conservative investors or those with long-term investment goals.

Are passive funds better than active?

The judgment between between passive and active funds depends on investor preferences and goals. Passive funds offer simplicity, lower costs, and alignment with market trends, while active funds rely on managerial expertise for potentially higher returns.

How do passive funds work?

Passive funds work by mirroring the performance of a designated market index, holding a diversified portfolio that replicates the composition of the index. This strategy aims to capture the overall market movements.

Which is an example of passive investing?

Index funds and exchange-traded funds (ETFs) are examples of passive investing.

How do I begin investing in passive funds like index funds?

You can start investing in passive funds like Index funds through the Bajaj Finserv app. It is advised to regularly monitor your investments to ensure they stay in line with your objectives.

Difference between passive and active funds?

Passive funds aim to mirror specific market indices and minimise buying/selling. Active funds involve frequent trading and seek to outperform the market.

Which is the best passive fund?

The best passive fund depends on your goals and risk tolerance. Consider popular index funds or ETFs for broad exposure.

Are passive funds good?

Yes, for long-term investors seeking diversification and lower fees. They provide stability and track market performance.

Why are passive funds gaining popularity in India?

Passive funds are gaining significant popularity in India due to a confluence of factors. Firstly, their low-cost structure, driven by lower expense ratios compared to actively managed funds, makes them a cost-effective investment option. Secondly, the simplicity of passive investing appeals to many investors, as it eliminates the need for complex stock selection decisions. Lastly, the historical difficulty of actively managed funds to consistently outperform their respective benchmarks has led many investors to embrace the passive approach. The emergence of a wide range of passive fund options and increasing investor awareness have further fueled this trend.

What are the advantages of passive mutual funds?

Passive funds offer several key advantages. Firstly, they provide instant diversification by investing in a basket of securities, reducing the risk associated with individual stock performance. Secondly, their low expense ratios contribute significantly to higher long-term returns. Thirdly, passive funds tend to align well with long-term market trends, offering consistent returns over time. These factors make them a compelling choice for investors seeking cost-effective portfolio growth.

Are there any disadvantages of passive funds?

While passive funds offer numerous benefits, they also have certain limitations. One key drawback is their lack of flexibility. Passive funds are designed to track a specific index, which means they cannot actively adjust their holdings based on changing market conditions or capitalize on specific investment opportunities. This inflexibility can potentially limit returns in certain market scenarios.

How do expense ratios impact passive fund returns?

Expense ratios represent the annual fees charged by the fund manager to manage the fund. Lower expense ratios directly translate to higher net returns for investors. By minimizing these costs, passive funds offer a significant advantage over actively managed funds, which typically have higher expense ratios.

How are passive funds taxed in India?

Passive equity funds in India are subject to the same tax treatment as actively managed equity funds. Short-term capital gains, realized within a year of investment, are taxed at a flat rate of 15%. Long-term capital gains, realized after holding the fund for at least a year, are generally tax-free up to ₹1 lakh per year. Any long-term capital gains exceeding this threshold are subject to a 10% tax, without the benefit of indexation.

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The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

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