Mutual Funds: What are passive funds and how do they simplify equity investing?

That the equity bourses are unpredictable and tricky is hardly a revelation. But, what if we told you that there is a way of investing in equities, not having to worry about cherry-picking your stocks, not bothering (too much) about market vagaries and still being able to benefit from the equity markets.

Does this sound too good to be true? Well, it's very simple, look at passive investments like index funds and Exchange Traded Funds (ETFs).

“Passive funds are particularly appealing to those who believe in efficient market principles and prefer a straightforward investment approach,” says Sumit Bhatnagar, Fund Manager – Equity, LIC Mutual Fund Asset Management about passive funds in the Indian investment context.

Passive funds in India replicate the performance of a specific index and are suitable for investors looking for cost-effective, diversified exposure to the market with minimal management and tracking error.

Passive funds as their nomenclature indicates are passively managed and designed to replicate the performance of a specific index, for example, S&P BSE 500 or Nifty 50. They hold a fixed portfolio of stocks as per the index composition.

Passive funds have a low cost and simplicity are major advantages, but they lack the flexibility of actively managed funds. As awareness about passive investing grows, Indian investors have also begun to appreciate the benefits of passive funds, such as lower costs, diversification, and alignment with long-term market trends, say experts.

“Investors who are new to investing or lack the time, knowledge, or interest to research individual stocks may find passive funds a straightforward way to gain exposure to the market without needing to pick individual securities,” suggests Bhatnagar about the investment priorities of such funds.

While investing in passive equity funds, just like any other equity investment, investors should have a long-term investment horizon. They benefit from the compounding of returns over time and can withstand short-term market fluctuations. Since passive funds often provide diversified exposure to a broad market or sector, they can help reduce individual stock risk. “This appeals to investors seeking a more conservative approach to investing,” notes Bhatnagar.

“While passive funds offer simplicity and low fees, active funds provide a dynamic approach that can be particularly advantageous during market corrections,” says Rahul Bhutoria, Director and Founder, Valtrust, highlighting the differences between passive funds and their actively managed counterparts.

So an index fund will have negligible cash levels to take advantage of any market opportunity. However active funds may hold cash and use this to capitalise on a market correction.

Moreover, an index fund will have to buy a stock even if a sharp correction is happening. Do note that an active fund does not have such a compulsion.

To cite an example both the Nifty 50 and Nifty Next 50 had shed 2% and 8% respectively since the Adani debacle broke out a few months back.

In such a scenario it was seen that Index funds were helpless and unable to do much more than just witness the sharp correction. The inclusion of a stock in an index is based on the market cap, till the time the stock has the required market capitalization, it continues to be a part of the index. “An investor, who is invested in such an index has nowhere to go,” says Bhutoria.

As against this, when Adani group stocks were correcting, some active funds had taken advantage of the same and benefited from the call. But again, as with all market related investments, the key differential should be your (the investors) investment priorities and objectives, not market movements.

Like any other equity investment, passive equity funds should also be evaluated in the broader context of an individual’s risk appetite and unique needs and circumstances. So, whether to invest in a large cap or mid cap or a small cap or sectoral passive fund should be a function of an individual's risk appetite and investment horizon.

“While evaluating a passive fund, investors should look at the fund’s tracking error, tracking difference, expense ratio, and in case of ETF, liquidity on the exchange etc,” advises Bhatnagar.

Passive funds typically have a lower TER (total expenses ratio) than active funds and an ETF would have a lower TER than an Index fund. Investors should also note that in the case of an ETF they also have to bear the cost of trading on an exchange platform, just like any equity shares.

“There is no standard rule or defined allocation towards passive strategy,” says Bhutoria when asked about how much asset allocation an investor could split between passive and active funds.

The exposure to passive funds in a portfolio depends on various factors, such as an individual's investment goals, risk tolerance, time horizon, and personal preferences.

“As awareness about passive investing grows, Indian investors have also begun to appreciate the benefits of passive funds, such as lower costs, diversification, and alignment with long-term market trends,” says Bhatnagar.

A background of passive funds in India

Passive investing has had an evolutionary journey since they first appeared in India some 25 years ago. From Nifty, Sensex Index funds introduced back in late 90’s, now there are Index and ETFs across market capitalizations. There are passive funds on factors of investing like momentum, value, quality, growth etc. and even sectoral funds.

Many fund houses now offer passive funds offering exposure to foreign indices. Now even in the fixed income segment there are a few offerings around the G Secs and Liquid funds category. In the commodities spectrum, currently there are gold and silver passive funds.

Though the passive funds currently continue to be dominated by institutional investors like pension funds, insurance companies, corporate treasuries etc, they are slowly gaining popularity among retail investors as well.

Passive funds and taxation

Passive equity funds have the same taxation as an active equity fund or an equity share. There is no difference. Short-term capital gains are taxed at a flat rate of 15%. When you sell your passive equity fund units after holding them for at least a year, you realise long-term capital gains. These capital gains are tax-free, up to ₹1 lakh per year. Any long-term capital gains over this threshold are subject to a 10% LTCG tax, with no benefit of indexation.

Manik Kumar Malakar is a personal finance writer.