Investing in passive funds? 3 important things you should keep in mind before going for it

Passive funds have gained significant traction in India over the past few years, increasing their market share from 1.4% of the mutual fund industry’s assets under management (AUM) in 2015 to 17% today. 

Data from the Association of Mutual Funds in India (AMFI) shows that the total AUM of all passive funds surged to over Rs 9.62 lakh crore by April 2024, up from Rs 83,000 crore at the end of FY18—an 11-fold increase in less than six years.

Passive investing involves creating a fund portfolio that closely mirrors a market index, contrasting with active management, where a fund manager strives to outperform the market using various strategies. The approach results in significantly lower costs for investors. 

For example, the average expense ratio of the top 10 equity funds is 1.94%, compared to 0.30% for the top 10 passive funds.

Sharwan Kumar Goyal, Fund Manager and Head of Passive, Arbitrage, and Quant strategies at UTI AMC, attributes the growth of passive funds over the past 8-10 years to their low cost and simplicity in generating market returns (beta).

He also points out that retirement funds invest 10-15% of their annual accretion in passive funds, contributing to their phenomenal growth. “We are also witnessing strong interest in these funds from distributors and retail investors in recent times,” he says.

If you’re considering investing in passive funds, here are a few key points to keep in mind:

First, ensure that an ETF closely replicates the underlying index. If an index has delivered 10% returns, the ETF’s returns should be similar. The ‘Tracking Error’ metric measures how closely the ETF’s performance matches the index. A smaller tracking error indicates a better investment outcome.

Second, check the expense ratio. Lower expense ratios are more favorable for investors. Additionally, assess liquidity. Market cap-based ETFs like Nifty and Midcap are more popular and have higher trading volumes. “Liquidity for ETFs is like water for fish; it’s critical that when investors attempt to buy an ETF on the exchange, there should be sellers, and vice versa. There should be sufficient trading volume in a particular ETF to ensure that transactions occur at prices close to those displayed on the exchanges,” explains Arun Sundaresan, Head of ETFs at Nippon Life India Asset Management. “Liquidity, essentially good trading volume, is very important in the context of ETFs and has a direct bearing on returns,” he adds.

Third, consider the overall cost of ownership when buying ETFs and index funds. In addition to AMC fees, investors must also pay demat charges and broker commissions. ETF investors need to be mindful of the total cost of ownership, while index funds have a bundled cost of ownership, meaning investors only pay the total expense ratio.

Given the recent boom in the Indian market, these costs may prove negligible compared to the returns from passive investing. So, if you are optimistic about the markets, passive funds can give your portfolio a substantial boost.

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