Passive Index Funds by DSP

Imagine a way to invest where you don't have to pick and choose stocks or commodities yourself. That's what passive funds do. They follow a market index, like the Nifty 50, by holding the same stocks in the same proportions as the index.

If the Nifty 50 index includes 50 different companies, a Nifty 50 index fund will also include those same companies. The goal here isn’t to beat the market but to match its performance. This means that when the market goes up, your investment goes up, and when it goes down, so does your investment.

In the case of a commodity like gold, a gold ETF will invest in physical gold (physical gold bars of 99.5% purity (Source: AMFI, Knowledge Centre, Gold ETFs ). The value of the fund will move up or down with the price of gold.

Because passive funds simply follow the market, they don’t require a lot of management. This keeps the costs lower compared to actively managed funds where a manager is constantly making decisions about what to buy or sell.

In short, passive funds offer a simple, low-cost way to invest by mirroring the market. They’re easy to understand and can be a good fit for many investors looking for a straightforward investment option.

In India, there are several types of passive funds that investors can choose from. These include:

1. Index Funds: These funds replicate a specific stock market index like the Nifty 50 or Sensex. They aim to mirror the performance of the index by holding the same stocks in the same proportions.
2. Exchange-Traded Funds (ETFs): ETFs are similar to index funds but are traded on stock exchanges like individual stocks. They can track indices, sectors, commodities, or other assets.
3. Fund of Funds (FoFs): These are mutual funds that invest in other mutual funds, including index funds and ETFs. They provide diversification across different asset classes and fund managers.
4. Debt Index Funds and ETFs: These funds track fixed-income indices, such as those for government bonds or corporate bonds, providing exposure to the debt market.
5. Gold ETFs: These ETFs invest in physical gold and aim to track the domestic price of physical gold. They provide a way to invest in gold without holding physical gold.
6. Silver ETFs: These ETFs invest in physical silver and aim to track the domestic price of physical silver. They provide a way to invest in silver without holding physical silver.
7. International Index Funds and ETFs: These funds invest in indices of foreign markets, allowing Indian investors to gain exposure to global equities.
8. These types of passive funds cater to different investment preferences and risk appetites, providing various options for investors to passively manage their portfolios.

Exchange-Traded Funds (ETFs) are a type of passive fund that trade on stock exchanges just like shares of listed companies. To invest in ETFs, you need both Demat and trading accounts.

ETFs are listed on stock exchanges, and you can buy or sell ETF units at market prices throughout the trading day. When buying ETF units, you purchase at the offer or ask price, which is the price sellers are willing to accept. Conversely, when selling ETF units, you do so at the bid price, which is the price buyers are willing to pay.

Unlike mutual funds, which disclose Net Asset Values (NAVs) at the end of the day, ETFs have real-time NAVs, known as intraday or indicative NAV (iNAV). Asset management companies (AMCs) update iNAVs every 10-15 seconds to reflect the estimated fair value of the ETF. However, the market price of an ETF can differ from its iNAV due to factors like liquidity, trading volumes, and market conditions. AMCs appoint market makers to ensure liquidity in ETFs.

Investors can also buy or sell ETF units directly with the AMC if they are dealing in large lot sizes, known as creation units. These transactions are based on NAVs. However, since creation units are quite large, most retail investors prefer to trade ETF units on the stock exchange through their trading accounts.

ETFs offer a flexible and transparent way to invest in a variety of assets, making them an attractive option for many investors.

Index funds are passive mutual fund schemes that track an underlying market benchmark index .

You do not need demat account to invest in index funds. Like any other open- ended mutual fund scheme you can invest or redeem units of your index fund directly with the AMC, either directly or through your mutual fund distributor. Unlike ETFs, index fund transactions take place at applicable NAVs (end of day NAVs). Index funds offer the benefits of cost efficiency, convenience and flexibility of mutual fund schemes.

ETFs and index funds are similar in many respects since both are passive funds, but there are some important differences between the two:-

• Buying: You can buy ETF units on the stock exchange at market prices (unless you are transacting in lot sizes or creation units). You can invest in index funds with the AMC either directly or through your mutual fund distributor at applicable NAVs.
• Selling: You can sell ETF units on the stock exchange at market prices (unless you are transacting in lot sizes or creation units). Liquidity is an important consideration when you are selling your ETF units. In extreme market conditions, you may not find sufficient buyers or be forced to sell your units at a prices lower the iNAV. You can redeem units of your index funds with the AMC either directly or through your mutual fund distributor at applicable NAVs.
• Demat account: You need demat account to invest in ETFs. Demat accounts are not needed for index funds.
• Invest through SIP: You cannot invest in ETFs through Systematic Investment Plan (SIP). You can invest in index funds through SIP
• Expenses: The TER of ETFs is usually lower than that of index funds. However, you may have to incur other transaction charges in ETFs. Overall, ETFs can be more cost efficient than index funds.

Both passive and active funds have their own advantages and drawbacks. Here’s a look at the pros and cons of each to help you decide which might be best for you:

Pros of Passive Funds

1. Less Risk: Active funds aim to outperform the benchmark market index by overweighting or underweighting certain stocks or sectors, introducing unsystematic risks in addition to market risk. Passive funds, however, do not take these positions and only carry market risk, making them less risky in terms of unsystematic risk.
2. No Human Bias: Passive funds eliminate the risk of human error or bias since they simply follow the index. The performance remains stable even if the fund manager changes.
3. Lower Expenses: Passive funds generally have lower Total Expense Ratios (TERs) compared to active funds, which means they don't have to outperform by a large margin to be cost-effective.
4. Simplicity: Investing in passive funds is straightforward. You don’t need to worry about the fund manager’s strategy—just choose a fund based on your risk appetite and low tracking errors.

Cons of Passive Funds:

1. No Alpha: Passive funds will always slightly underperform their benchmark index due to fees. Active funds, however, have the potential to outperform (create alpha), which can result in potential higher wealth creation over time due to compounding.
2. Risks: Passive funds, particularly ETFs, face liquidity risks, trading risks, and tracking errors (the difference between the fund’s returns and the index returns).
3. Limited Options: Active funds offer a wider variety of investment choices across different asset classes, market segments, and investment strategies. This can provide more tailored solutions for varying risk appetites and financial goals.

Conclusion:

Both active and passive funds have their place in a well-rounded investment portfolio. Passive funds provide a low-cost, low-risk way to mirror market performance, while active funds offer the potential for higher returns through expert management. To make the best choice, consider consulting a financial advisor who can help align your investments with your risk profile and financial goals.

• Your risk appetite:
  First, understand your own risk tolerance. Are you comfortable with the highs and lows of equity markets, or do you prefer the steadiness of fixed income? Within equities, broad market funds like Nifty or Sensex ETFs offer diversification, while sector-specific funds like IT or Healthcare ETFs target specific industries. Fixed income options vary by duration, and you can even explore commodities and international equities. The key is to balance your portfolio according to your risk profile, and a financial advisor can help tailor this to your needs.
• ETFs vs. Index Funds
  Next, decide between ETFs and index funds. ETFs trade like stocks, making them suitable if you’re familiar with the stock market’s ins and outs. They allow you to benefit from intraday price movements and often have lower costs. Index funds, however, offer the simplicity and convenience of mutual funds, with no need for a demat account and options for SIP/STP investments. Choose based on your comfort level and investment habits.
• Focus on Tracking Error and TER
  When selecting a specific fund, pay close attention to two key metrics: tracking error and Total Expense Ratio (TER). While a low TER often means a low tracking error, it’s not the only factor. Efficient trade execution and cash management also impact tracking error. Compare funds tracking the same index and go for the one with the lowest tracking error

Final Advice
Always consider consulting a financial advisor or mutual fund distributor if you’re unsure. They can provide personalized advice to help you choose the best passive fund for your investment needs.

Remember, investing is a journey, and choosing the right passive fund is a step towards a balanced and potentially rewarding portfolio.