Explained: All you need to know about investing in passive funds

“Index funds are like any other mutual fund scheme that invests in the constituents of an underlying index in the same proportion as in the index. ETFs are index funds but listed on the stock exchange so that they can be bought and sold real-time during market hours,” Ghelani explains.

To cater to growing demand amongst different categories of investors, Ghelani tells that mutual funds and index providers have come up with many options across various segments of the markets, both in equity and fixed income.

“As an example, if an investor is looking to park money in the broad market, there are index funds/ETFs like Nifty 50, Nifty Next 50, Sensex 30. If the requirement is to invest in the mid and small-cap space at a low cost, without going through the hassle of selecting individual stocks, there are market capitalization-based indices. To participate in sectoral cycles, indices like the Nifty Bank index or Nifty Healthcare index have been packaged as index funds. For the more savvy investors, smart beta or factor-based indices are offered that follow a rule-based approach to include/eliminate stocks e.g. the Nifty 50 equal weight index or the Nifty Alpha Quality Low Volatility Index,” he explains.

Index Funds and ETFs offer investors an opportunity to invest passively.

As per Ghelani, individuals can invest either directly from the AMC’s website or through various digital or online platforms. Like any other mutual funds, they can invest in a lump sum amount or set up a SIP to systematically invest on a periodic basis.

“In the case of ETFs, they can invest real-time during market hours. To buy/sell ETFs, an investor would require a trading account with a broker and a demat account to hold the ETFs,” he elaborates.

Since the base of the passive fund’s portfolio will come from the index that it is tracking, it is very important to understand the logic of that index, the selection and elimination criteria of stocks and risks involved in that strategy.

After selecting the index, Ghelani tells that the decision to buy an ETF or Index Fund depends on the need. Both are good in their own way.

"For retail or HNI investor who is looking to invest for the long term and is not concerned with intraday prices, index funds are a good option. An investor can do SIP in index funds but not in an ETF. There are certain entities that are not permitted as per their internal guidelines to have stock broking and demat accounts. So, such entities can also invest in index funds," Ghelani states.

In an ETF, investors need to see what is the total cost of ownership (TCO) and not just the total expense ratio (TER).

"The TCO includes all expenses including brokerage and other taxes paid on buy and sell transactions on the stock exchange, annual demat account charges, bid/offer spread, etc. Suppose, an investor has Rs 100 to invest and his/her equity and debt allocation is 60:40. Of Rs 60, he/she can wish to invest Rs 50 in large-cap, then invest Rs 25 in an active fund and the remaining Rs 25 in a passive fund. Mid and small-cap allocation can be in active funds. It's crucial to understand that passive funds shouldn't be used as a competing strategy but rather as a complementary strategy," Ghelani advises.

While passive investing eliminates a lot of risks that active funds hold – like fund manager bias and selection bias, it comes with its own set of risks.

According to Ghelani, it is important to keep in mind that market risk is applicable for both active as well as passive funds.

“Even passive funds will fall when the overall markets correct. A passive fund brings with it the risk of the underlying index it aims to track. So if, for example, the index fund is tracking the Nifty 50 Index, all the risks associated with the Nifty 50 Index such as downside risk of equity markets, volatility of stocks, etc. will apply to the fund as well,” he explains.