Photo: Mint
Photo: Mint

Explained: What are passive funds and what makes them low-cost options?

  • Passive funds invest in a portfolio that replicates a market index such as the Nifty or the Sensex
  • These funds aim to deliver returns in line with the index

Passive funds invest in a portfolio that replicates a market index such as the Nifty, the Sensex or any other broad market or sectoral index. The securities held and their proportion in the portfolio will be the same as the index the fund tracks.

These funds aim to deliver returns in line with the index. The portfolio of a passive fund changes only when the constitution of the index changes. Investors buy passive funds when they want returns in line with the market, at low costs and without the risks associated with the fund manager’s decisions on what stocks to buy and how much exposure to take in these securities. Since there are no costs involved in researching and selecting stocks, passive funds have low expense ratios.

Passive funds are of two types. Index funds are structured like an open-ended scheme where investors buy and redeem units directly from the mutual fund at the applicable net asset values (NAV). Exchange-traded funds (ETF) too invest in a portfolio of securities that duplicates an index. Units of an ETF are mandatorily listed on a stock exchange and investors buy and sell units at real-time prices through their demat account. The price at which ETFs trade are linked to its NAV and the demand and supply of units in the market.

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