Passive Funds: Are They The Right Choice?

Mutual funds are the most convenient and simplest way to invest in stocks, especially for first-timers or investors with little knowledge of the stock market. Mutual funds can be majorly categorized into active funds and passive funds.Active funds are more actively managed by experienced fund managers, who, along with their team of researchers and analysts, work towards picking the stocks expected to deliver higher returns.  On the other hand, Index funds track the market movement and deliver results in-line with these movements.Let's understand what passive funds are and how do they work:

Passive funds , as the name suggests, are more passive in nature. While they are managed by fund managers too, their role is more limited to just tracking a market index to fetch returns for their investors. Unlike an active fund where the manager decides upon which securities to purchase to generate the highest possible return, the index funds simply map with an index's movement. The returns are dependent on the performance of the index that the fund is following. So, if the index is performing higher, the returns will be higher too and vice versa.

The basic idea behind passive investing is to replicate the returns generated by an index.So, what do we mean by an index here? An index can be looked upon as a group of similar stocks that are already listed on the exchange. The stocks may be similar in their industry types, company size, market capitalization, etc. If most of the stocks in the index perform well, the overall index will rise and vice versa.Some of the indices in India are as follows:

• Broad-based indices- Nifty 50, Sensex 100
• Benchmark indices- NSE Nifty, BSE Sensex
• Nifty FMCG and CNX IT (Based on sectors)
• BSE Smallcap/Midpacp (Based on Market Capitalization)

For example, if you wish to invest in NIFTY 50 index funds, you will be allocated the top 50 stocks in a similar ratio as the index. So, if a company X has a 15% stake in the NIFTY 50, 15% of your funds will also be allocated towards company X stocks. The ultimate objective behind allocating stocks in the same proportion is to replicate the performance of that index. Since we do not need any expertise in this allocation, passive funds are low cost.

While the passive funds are still evolving, investors are getting interested in them due to the equity mutual funds performing below the benchmark in recent times. Let’s look at the popular index fund options available to investors today.

• Major Indices These mainly include NIFTY 50, and the SENSEX. 21/36 index funds and 26/80 ETFs (Exchange-traded Funds) are based on these indices. Other options under this category are nifty 100 and nifty next 50. Since these indices include large-cap stocks that are highly liquid, there are lesser chances of tracking errors with these funds.
• Other Market Capitalization Indices These include indices based on small-cap and mid-cap segments such as Nifty Midcap 100/150, Nifty Smallcap 250, BSE select Midcap, BSE 500/Nifty 500, etc.
• Sector Based Indices Under this category, the options are limited and mainly based on banking and financial services, such as the NIFTY-bank index fund. Most of the sector-based indices fall under ETFs and not under index funds.

While passive funds come with many benefits, we must not forget that since index funds religiously follow the index, they don't have much scope to outperform the benchmark. The returns are generally moderate that can match the benchmark but sometimes also cross it. When a fund manager is able to do that over a consistent period of time, the fund is said to have generated a positive alpha.

Index funds are suitable for individuals who don't have time or knowledge to monitor their investments. They have a low expense ratio since the fund manager's role is less active in picking suitable stocks. Also, due to a fund manager's minimal role, there are lesser chances of any human bias or errors.However, one drawback of passive funds is that your investment gets over-exposed to a limited number of stocks and sectors, restricting your chances of returns.Hence, if you wish to keep the investment simple with a low-risk, low expense ratio and moderate profits, you may consider investing in passive funds. If you are striving for higher returns, active funds are recommended since fund managers can help you outperform when the market is stressed.Active managers generally outperform when the market conditions are volatile, while passive investing is beneficial at other times. Hence, you may also consider mixing both active and passive investment styles to leverage market conditions at different times and strive for higher returns.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.