Things to keep in mind before investing in a passive fund

● Invest as per risk profile -

Before selecting a fund to invest in, investors must invest as per their risk profile. Most investors tend to chase returns without looking at the volatilityrisk of their investments. This is a dangerous strategy and often leads to poor investments. For example, a small-cap fund that has delivered 80% returns in the past is in almost no way a good investment for a customer looking to grow wealth and a conservative or moderate investor. Index funds come in different forms ranging from the simple large-cap Nifty 50 fund to small-cap index funds to sector funds. Investors should be comfortable with volatility risk before investing in them. A key observation is that investors lose capital not in bad investments but in investments that don't suit their risk appetite.

● Index funds vs ETFs - Index funds are structured to be similar to mutual funds. They can be bought daily directly from the mutual fund. Investing in an index fund requires no demat account and can set SIPs at ease.

ETFs are essentially index funds that are traded on the exchange. Therefore, the price of ETFs is dynamic and tracks the live prices of the underlying stocks - making it effective for investors who wish to trade using ETFs. Both (Index funds and ETFs) are equally effective in terms of long-term wealth creation. However, investors should watch out for differences in prices on the exchanges and the underlying stocks (called iNAV) for ETFs. ETFs in India are inefficient due to a lack of trading on the exchange. Hence, investors should check the correct price before purchasing on the exchanges.

When choosing the right index fund, investors may run into the problem of choice, whereby many mutual funds are offering the same choice. For example - the Nifty 50 index fund is today offered by many mutual funds. Although most of them are very similar, a key difference is expense ratio and tracking error.

Tracking difference - Tracking difference is the difference between the returns of the index and the returns of the fund. It's almost impossible for a fund to track or replicate the benchmark perfectly. The cost of trading, tax, and expense ratio leads to a small tracking error every year. Investors should watch out for funds with high tracking errors. For funds with a similar tracking error - go ahead with fund houses with the most experience and number of products in passive funds.

● Expense ratio - Index funds are popular because they are cheap. Over the long term, there is a positive relationship between expense ratios and tracking error. What that means is that the lower the expense ratio, the lower the tracking error. However - investors should not blindly go for the cheapest index fund. A combination of track record and expertise is equally important. In many cases - the lowest cost fund does not have the lowest tracking error.

● Sector funds - Sector funds are better seen as in-between stocks and mutual funds. Investors looking to take a call on the short - medium-term growth of a sector/theme without buying a particular stock could use sector funds in the right way. They tend to be more volatile and require some element of market timing to maximize their effectiveness in the portfolio. Most investors are better off in diversified mutual funds for their long-term needs.

● International funds - International index funds are another area of interest. The rupee depreciates by 2-4 percent every year. So a global fund provides currency protection as well as gives additional portfolio diversification. And they are a great way to own stocks like Apple, Google, Netflix and many others. Unlike India, where both active and passive funds are equally effective - developed markets such as the US - passive funds tend to be preferred by investors.

● Asset allocation - Where index funds shine is asset allocation. Today investors can build low-cost portfolios using index funds and ETFs. In addition, there are good choices of passive offerings in debt, equity, gold, international - making it easy for investors to build portfolios.

In conclusion - passive funds in index funds and ETFs have made life easy for investors. With the growing popularity of index funds and choice - it remains important that investors take the proper steps before selecting the right passive fund.