Passive Mutual Funds are funds that replicate a market index like Sensex or Nifty. These funds invest in the constituents of the index that they track in the same proportion that makes the Index. Fund managers of such funds DO NOT do any research of their own to identify the stocks or bonds that they can invest in.
For e.g., if a fund is tracking Sensex, then it will invest in the 30 Sensex stocks in the same ratio that makes the Sensex.
Advantages of Passive funds:
- They have lower costs and fees as no additional amount is spent on identifying opportunities
- Most cost effective way to diversify your portfolio as these stocks make the top companies of the economy. The exposure is also across different industries.
- As an investor you do not need to spend a lot of time to analyse and evaluate which passive fund is performing the best
- Reduced risk – as fund manager is not actively managing the fund
- Transparency – as composition of the portfolio is known to everyone
Different types of Index funds:
- Index Mutual funds – these are mutual funds that invest in an index
- Index ETF – these are exchange traded funds similar to mutual funds but can be traded during the market hours
- Fund of Funds – A fund of fund may invest in multiple funds that invest in Indexes
- Smart Beta funds – these fund invest in index itself but may make some changes to their portfolio based on market movements.
The most important things to know in choosing a Passive Mutual Fund are:
- Decide what Index you want to invest in – Nifty 50, Nifty 100, Sensex etc, Midcap etc
- Tracking Error – A passive fund cannot match the movement of the Index a 100% at all times. Sometimes it may lag behind, for all new funds that come in and go out from the fund, deployment and redeeming of the money can have a lag. Deployment of dividend into the Index in the same ratio of its constituent may get delayed, hence this can cause a small difference in the performance of the Index and the fund by itself. This difference is called the Tracking Error. One should choose fund with the least tracking error.
