Passive fund
A scheme that invests according to a specified index, holding its shares in the index's own weights, so it mirrors the index instead of trying to beat the market — and costs little to run.
In plain language
A passive fund makes no bets. It invests on the basis of a specified index, whose performance it seeks to track.
Chapter 2's illustration: a passive fund tracking the S&P BSE Sensex buys only the shares in the Sensex, and holds each in the same proportion as its weightage in the index. Its performance therefore tends to mirror the index. It is not designed to perform better than the market.
Because the index decides the portfolio, the fund manager has no role in deciding on investments, and such schemes have low running costs. The workbook says they are also called index schemes, and Chapter 4 says an index fund is also called a passive fund.
How it works
What the fund team still does. Chapter 4: manage inflows and outflows from purchases and redemptions, and ensure the portfolio tracks the index. It does not decide which securities to buy or sell, or when.
The two main wrappers.
| Index fund | ETF | |
|---|---|---|
| Transacted | Open-ended — with the fund, at the day's NAV | On a stock exchange, at market prices through the day |
| Nature | Passive | Usually tracks an index — passive in nature |
| SEBI category rule | Minimum 95% of total assets in securities of the index tracked | Same category |
Costs. The total expense ratio of index funds is very low, and SEBI has allowed a lower limit on the maximum expenses that can be charged.
Measuring a passive fund. The yardstick is tracking error — the annualised standard deviation of the difference in returns between the fund and its index, computed against the Total Returns Index. An index fund manager must calculate it daily. The measure of a good index fund is a very low tracking error.
The wider framework. SEBI's MF Lite framework is for passively managed schemes — a mutual fund having only index funds, ETFs and fund of funds, or schemes SEBI specifies. Index funds and ETFs tracking different indices are an exception to the one-scheme-per-category rule, and smart beta funds extend the idea by changing the weighting basis.
A worked example
A passive fund tracking a 30-stock large-cap index has Rs 1,000 crore of assets. Figures are illustrative.
Portfolio. If one bank stock has a 10 percent weight in the index, the fund holds about Rs 100 crore of it. The category rule requires at least Rs 950 crore (95 percent) in index securities; only the remaining 5 percent may sit outside them.
A day of redemptions. Investors redeem Rs 20 crore. The manager does not choose which shares to sell — the fund sells a slice of every constituent in index proportions.
A year's result. The index's total return is 12.0 percent; the fund returns 11.6 percent. The 0.4 percentage point gap is the cost of running the fund and of imperfect tracking. On Rashmi's Rs 3,00,000:
Index return on Rs 3,00,000 = Rs 36,000
Fund return on Rs 3,00,000 = Rs 34,800
The Rs 1,200 difference is the whole cost of passive investing for her — and if the gap swings unpredictably from month to month, the high tracking error is the warning sign, not the small shortfall.
Why NISM asks about it
Chapter 2.2.2 (By the management of the portfolio) sets passive funds against actively managed funds, Chapter 4.3 (Index Funds) treats index funds as the passive product the new cadre of distributors can sell, and Chapter 7.4 defines tracking error. Expect: why passive funds have low costs (no fund manager role in stock selection), the 95 percent index-investment floor, and the true/false that a passive fund aims to beat the market (false).
Common exam traps
- A passive fund does not aim to outperform. Its target is to mirror the index.
- Passive is not the same as unmanaged. The team still handles flows and keeps the portfolio tracking.
- Weights match the index, not equal amounts in each stock — equal weighting is a smart beta strategy.
- A good passive fund is judged by low tracking error, not by high return.
- ETFs trade on the exchange; index funds do not — both are passive.
- The workbook uses index scheme, index fund and passive fund interchangeably.
Where this is taught
Free preparation for NISM Series V-ARelated terms
- Index fundsA passive open ended scheme that replicates or tracks a specific index, investing at least 95 percent of total assets in that index's securities, bought and redeemed from the fund rather than on an exchange.
- Total Expense RatioThe all-in annual cost of a mutual fund scheme as a percentage of daily net assets — the base expense ratio plus brokerage, transaction cost and statutory levies — charged to the scheme, not billed to the investor.
- Actively managed fundA scheme whose fund manager chooses the portfolio within the broad limits of the investment objective, aiming to beat its benchmark — at a higher running cost than a passive fund.
- Exchange Traded FundA mutual fund scheme whose units are listed and traded on a stock exchange like a share, so you transact at live prices through the day instead of at one end-of-day NAV.
- Total Return IndexThe variant of a market index that adds the dividends and interest paid by its constituents to their price movement — the only variant a mutual fund scheme may be benchmarked against since 1 February 2018.
- Tracking errorThe gap between the return of a passive fund and the return of the index it is trying to replicate — the measure of how faithfully an index fund or ETF does its one job.
- Smart Beta FundAn extension of index funds and ETFs that changes how the index is weighted — equal weights or other parameters instead of market capitalisation — to improve returns, diversify more and reduce risk.