What are Passive ETFs and How They Work

What is a Passive ETF?

A Passive ETF is an investment fund that attempts to follow the movement of a given index, like the Nifty 50 or SENSEX. It does not rely on the fund manager’s active stock selection, unlike actively managed funds. Rather, the portfolio aims to replicate the index composition and weightings as closely as possible.

These funds are listed on the stock markets as separate shares during the trading hours. They offer returns pegged to the markets at a lower cost rate than the funds under active management. The fund manager will only have the mandate to match the portfolio to the benchmark index, cash management, corporate actions, and reduction of tracking error.

How Do Passive ETFs Work?

Passive ETFs have a portfolio that is a close reflection of their underlying index. When the underlying index changes, the ETF adjusts its holdings accordingly. The buyers can also buy units through a demat and trading account on a stock exchange.

Authorised participants, typically large financial institutions, help maintain liquidity by creating or redeeming ETF units in large blocks. This mechanism helps keep the ETF's market price close to its net asset value (NAV), although minor deviations may occur.

Key Features of Passive ETFs

These are the characteristics that would be generally revealed under scheme documents in explaining index-based investing:

1. Transparency and Cost Efficiency

   Holdings are index constituents that are publicly traded, and they are transparent. The expenses are normally low because there is not much active management that may favour high net returns in the long run.

   Tracking error is used to indicate the difference between benchmark returns and ETF returns. It is one of the key measures of how closely the fund tracks the index. The tracking error can be a result of expenses, rebalancing, corporate activities or uninvested funds held by the fund.

2. Diversification and Liquidity

   One investment gets exposure to several securities in the index chosen. Different ETFs have liquidity differences based on the trading volumes and the participation in the markets. However, price efficiency is supported by the authorised participants via the creation and redemption process. ETFs that have more than 65 per cent domestic equity are taxed as equity mutual funds.

   Non-equity ETFs, such as debt, gold, and international ETFs, are generally taxed at the investor’s applicable income tax slab rate under current tax rules, and indexation benefits are not available for investments made on or after 1 April 2023.

Benefits of Investing in Passive ETFs

Passive ETFs do not involve discretionary stock selection, thereby reducing fund manager-driven performance variation. They provide inexpensive exposure to the large market indices or industry in such a way that there is no high turnover of the portfolio. Equity-oriented ETFs with at least 65% domestic equity are taxed under equity mutual fund capital gains rules.

Such funds are typically used to obtain market-linked returns through index replication. They are often considered for long-term market participation due to their index-linked structure.