Are passive funds better than other funds?

These are a few misconceptions about passive funds, which lead investors to make some wrong decisions about passive funds.

Passive funds have become popular over the last few years and many investors feel they are safer than actively managed funds. Some investors believe that these funds can give them steady 15 per cent per annum returns annually. These are a few misconceptions about passive funds, which lead investors to make some wrong decisions about passive funds. 

Index Funds and Exchange-traded funds (ETFs) are passive funds where the fund manager mirrors a particular index and does not take any active calls on allocations to stocks or sectors. They are popular overseas as they have lower costs compared to actively managed funds. But this doesn’t make them safer. These funds invest in shares and hence carry market fluctuation risk. Will they fall lower than other funds is also not known and cannot be taken for granted. 

Over the last few years, new indices have come up like the Nifty Total Market Index. Asset management companies have come out with a slew of new fund offers riding the passive fund wave. The funds launched too were on trending sectors like defence, microcap, etc. About 30 passive fund NFOs came out in CY 2023. This is making decision-making difficult for investors. Apart from the Nifty 50 or Nifty 150 Midcap, most other indices are meant for investors wanting to take concentrated exposure to a theme or market cap. Factor funds that focus on certain parameters like low volatility, momentum, equal weightage etc are not fully understood by investors. Further, these funds do not have a track record of consistently beating the broader indices. 

Diversification is a challenge in passive funds. Investors tend to buy funds that mirror the same index but from different fund houses, for example, three Nifty 50 index funds. This makes the portfolio concentrated in favour of a few stocks or sectors. To avoid this, investors should invest across market caps. 

Investors are never sure how long to remain invested in the fund and tend to exit when they see other funds doing better. As with all equity funds, one needs to remain invested for at least 7-10 years to ride out the volatility in equities. 

While choosing any fund, investors should consider the following:

How long can the investment be held?

What is the risk that can be taken?

Is it possible to evaluate both active and passive funds or does the investor prefer to invest in the index?

In going the passive way, is the portfolio diversified across market caps?

Have the funds been evaluated on their tracking error? The tracking error shows how optimally the fund is being invested and is an important parameter in assessing passive funds. 

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