Passive Indexing in Mutual Funds

What is Passive Indexing?

Passive indexing is a type of investment in which a mutual fund recreates the structure and performance of a given market index. The fund manager is not actively making security selections or trying to beat the benchmark. Instead, the portfolio is expected to invest in the securities in the same proportion as the underlying index that it intends to follow, whether through complete replication or a sample strategy.

The fund is not discretionary in terms of security selection but follows the index methodology. This enables the fund to save on the management expenses as it trades less by mainly replicating the index composition.

How Passive Indexing Works

Passive plans in India usually follow indices like the Nifty 50, BSE Sensex, wider market indices, and industry indices. The fund then purchases the entire index or a sample of securities of that index. The weight of each security in the fund is aligned with its proportion in the benchmark.

When there is an increase or decrease in the index composition, either due to corporate activity or because of a periodical rebalancing, the fund undertakes changes in its holdings. This ensures that the portfolio continues to reflect the index composition. Performance alignment level is evaluated with the help of tracking error, indicating the standard deviation of fund and benchmark returns variation over time.

Characteristics of Passive Indexing

Passive indexing is a rule-driven investment strategy that aims to replicate the results of a given index in the market at a reduced cost.

• Low Cost Structure: Passive funds generally have lower expense ratios because they involve limited active research and lower portfolio turnover.
• Market Returns: The fund will seek to produce returns that are comparable to the index that it is tracking, and the costs and tracking error will be present. This is supposed to deliver long-term benchmark-aligned returns that are prone to market risks as well as tracking differentials.
• Transparency: SEBI requires mutual funds to periodically disclose portfolio holdings, allowing investors to compare them with the underlying benchmark. Investors can review portfolio holdings and understand where their money is invested.

Passive Indexing vs Active Management

Active management entails the fund managers making their own decisions in terms of investments so as to outperform the benchmark by the use of research and market timing. Passive indexing simply replicates the index with no attempt to beat it.

Active funds typically have higher fees due to the resources allocated to research, analysis, and frequent trading. Passive funds are more cost-effective and incur lower operating costs. However, active management seeks to outperform a benchmark through discretionary decisions, whereas passive indexing seeks to replicate benchmark performance. There are normally differences between the expense structure and portfolio turnover used in both approaches.

Key Takeaways

Tracking error and tracking difference are generally measured when passive mutual fund schemes are under analysis. A smaller tracking error means that there is improved replication of the index. Tracking difference refers to the deviation between the fund’s returns and the benchmark’s returns over a specific period. A larger tracking difference indicates a greater divergence from the benchmark.