Rising importance of including passive funds in the portfolio

Passive funds are popular globally and are increasingly becoming popular in India too. Unlike actively managed mutual fund schemes, which aim to beat a benchmark index, passive funds simply track the benchmark index or the price of commodity (e.g., gold, silver etc). The appeal of passive funds lies in their cost efficiency and simplicity, making it smart investment choices for many investors, including new investors. There are broadly three types of passive funds:-

• Exchange traded funds (ETFs) – These funds track benchmark indices or prices of commodities and are listed on stock exchanges. You can buy or sell units of ETFs on the exchange at prevailing market prices, just like you buy or sell shares of listed companies. You need to have demat accounts.


• Index funds – These funds also benchmark indices, however, unlike ETFs, index funds are mutual fund schemes. You can buy or redeem units of index funds with the asset management companies (AMC). Like traditional mutual funds, you can invest in index funds through SIPs.


• Passive Fund of Funds (FOFs) – These are mutual fund schemes which invest in ETFs or index funds. Passive FOFs can provide exposures to commodities (e.g., gold, silver), international equities etc to investors who do not have demat accounts.

Benefits of passive funds

• Low cost: Total Expense ratios (TER) of passive funds is much lower than actively managed funds. The fund manager of an active fund will have to generate significant alphas on a consistent basis to match the performance of a passive fund tracking the same benchmark index. Suppose the TER of an active fund is 1.5%, while that of a passive fund tracking the same benchmark index is 0.20%. This difference in costs implies that the active fund will have to consistently beat the benchmark by at least 1.30% to match the performance of the passive fund. Since funds in your core portfolio would have long investment horizons, lower cost of passive funds can give it a significant advantage.


• No unsystematic risk: The fund manager of an active fund needs to be overweight or underweight on certain stocks in the index to beat the benchmark index (create alphas). This will result in unsystematic risks or stock/sector specific risks. Unsystematic risk can lead to outperformance or underperformance depending on market conditions. There is no unsystematic risk in passive funds because the fund simply tracks the benchmark index – it does not aim to beat the benchmark index.


• No human biases: Fund manager biases can impact the performance of active funds. Additionally, the change of the fund manager of an active fund for any reason can affect the returns of the fund. There is no human bias in passive funds.

Passive funds can provide diversification

Broad market indices like Nifty 50, Nifty Midcap 150 and Nifty 250 are diversified across 15 to 20 industry sectors (see the table below). Actively managed diversified equity funds can be overweight / underweight on certain sectors relative to the benchmark index or may not have exposure to some sectors. Passive funds on the other hand are not heavy on a few sectors unlike active funds. Sector weights depend on the market caps of the companies in the sector.

Source: National Stock Exchange, as on 31^st October 2025

Simpler investments

The table below shows the average, median (mid performer), maximum (top performer) and minimum (worst performer) of different active diversified equity fund categories over last 3 years. You can see that in most categories there is significant differences between median and minimum returns. Even relatively minor differences in returns can have significant differences in wealth creation over long investment tenures due to compounding effect. Passive funds on the other hand, aim to replicate returns of benchmark index subject to tracking errors. Unlike investments in active funds, you do not have to spend time and effort in researching fund performance. You simply have to select a passive fund with low TER and tracking errors.

Source: Advisorkhoj Research, as on 27^th November 2025

Diversification across asset classes

VICTER Framework for selecting ETFs

How to invest in passive funds?

If you have demat and trading account, you can invest in ETFs. If you do not have demat account, you can invest in index funds or passive FOFs. Selection of passive funds will depend on the following factors:-

Conclusion

Passive funds can be cost effective and convenient investments to provide diversification to your investment portfolio. With increasing maturity in the passive space of our mutual fund industry, you will find a vast range of schemes across asset classes, investment tenures, market segments, industry sectors and investment styles / strategies. You should always invest according to your risk appetite. You should consult with your financial advisor or mutual fund distributor, which passive funds are suitable for your risk appetite and investment needs.