Passive funds: All you need to know

Summary: Want steady market returns without the stress of active stock picking? Passive funds offer a simple, low-cost way to track market indices like Nifty and Sensex while keeping your expense ratios minimal. Here, we've got everything you need to know about getting started.

Passive mutual funds are funds which replicate a market index like the Nifty or Sensex. These funds invest in the constituents of the selected market index in the same proportion as they are present in the index. Fund managers of passive funds do not conduct any research to pick stocks that can be part of their portfolios. For example, a passively managed fund tracking the Sensex will invest in the stocks of 30 companies that make up the index in the same proportion.​

As compared to active funds, these funds charge lower fees since they do not need to conduct in-depth research to select stocks. With these funds, you can opt for a cost-efficient way to diversify your portfolio and get exposure to a wide spectrum of market segments. With the rising popularity of passive mutual funds in India, you can not only diversify your portfolio but also get returns that match the market.​

How do passive funds work?

Passive investing revolves around choosing a market index and forming its replica by investing in the same stocks in a similar proportion as the index. After that, the fund starts tracking the index closely and making changes to the portfolio as per the underlying index in order to make the fund closely identical to the index. When it comes to passive funds, there is no process related to selecting stocks, as the stocks of these funds are similar to those of their underlying indices. Therefore, fund managers play a limited and passive role, which is the ultimate meaning of passive funds.

Different types of passive funds

Index funds

Index funds are passively managed mutual fund schemes that replicate specified market indices. These funds can be bought and sold like any other mutual fund scheme and work in the same manner. In passive index funds, the weightage of all stocks is similar to that of the underlying index. If a stock's weight in the underlying index changes, the fund manager also buys or sells units to match the weightage of the index.

However, these funds do not always yield the same results as their underlying indices because of tracking errors. These happen when it is difficult to hold the securities of indices in similar proportions. Nevertheless, these funds are appropriate for those investors who want exposure to the broader market without investing in stocks or mutual funds directly.

Exchange-traded funds (ETFs)

ETFs are passively managed schemes replicating specified market indices. However, unlike traditional mutual funds, units of ETFs are traded on the stock exchange like equity shares, and their price varies based on the NAV (net asset value). ETFs generally have a lower cost (expense ratio) as compared to index funds. In terms of daily liquidity, ETFs outperform mutual fund schemes because they trade throughout market hours.

Fund of Funds (FoFs)

Unlike an index fund or an ETF, an FoF may not necessarily track an index. These schemes invest in one or more mutual fund schemes. However, in certain FoFs, the fund manager actively decides how much to invest in which mutual fund scheme and may change the allocation on an ongoing basis. Such FoFs cannot be called passive funds.

Smart-beta funds

Smart-beta funds mix the benefits associated with passively managed funds with the selection of active investments on the basis of specific criteria such as value, momentum or quality. This paves the way for the fund to yield higher returns by using a cost-effective model. These funds follow the underlying index when it comes to performance, but make changes to their portfolios based on market moves. Similar to ETFs, these funds lack fund manager bias.

Advantages of investing in passive funds

Low on cost: ETFs and index funds have a lower expense ratio than any active mutual fund scheme. The primary reason is that they don't have any significant role for the fund manager, as the portfolio is simply replicated from the chosen market index.

Reduced risk of fund management going wrong: Although fund managers of actively managed schemes try their best to make investment decisions which are likely to return more than the index, sometimes they may go wrong. Since an index fund replicates the market index, there is a reduced risk of such instances.

Exposure to the broad market: A benchmark consists of the stocks that constitute the sector or market as a whole. So, if you invest in a passive fund that tracks the benchmark, it will give you exposure to a vast range of stocks that represent the market movement.

Easily manageable: If you invest in passive funds, you do not need to track the performance of the fund or its fund manager. Since these funds closely replicate their underlying benchmarks, you can expect a return that is close to that of your fund's underlying benchmark.

Transparency: These funds show all their underlying assets, and ease of trade has contributed to the popularity of passive funds. ETFs, in particular, can be sold and purchased anytime on the trading day.

Disadvantages and risks of passive investing

Underperformance: You lose the opportunity of earning higher returns than the market index. Since the fund manager is bound to replicate the portfolio of the market index, investors lose the possibility of earning higher returns compared to active strategies.

Less flexibility: During a market decline, the fund manager does not get the option to change the allocation in the fund's portfolio to lessen the impact of the market slump. These funds do not provide any flexibility to their fund managers.

Tracking errors: These errors signify the inaccuracy of a fund in tracking its underlying benchmark. A lower tracking error indicates better performance.

Fee structure and investment strategy

Passive mutual funds have significantly lower total expense ratios compared to their actively managed peers because they do not need active selling and purchasing of securities. Since they replicate the benchmark, the fund manager does not need to track their portfolio quite often.

When it comes to the investment strategy of passive funds, it mainly focuses on buying and holding. Their fund managers do not need to give time and effort to rebalance their portfolios actively. These funds use a host of investment strategies, including tracking a broad market index or a sector index.

Returns and taxation

Passive funds intend to mimic benchmark indices closely. In other words, there is hardly any difference between passive mutual funds and their underlying benchmarks in stock representation and portfolio composition. Given that the compositions are almost similar, returns from these funds are nearly the market returns. 

Passive funds do not intend to outperform their underlying indices. Instead, the main objective of these funds is to gain benchmark returns as nearly as possible. Compared to active funds, risks are lower in passive mutual funds.

Given that these funds aim to replicate their underlying benchmark indices, their taxation will be based on the composition of their underlying indices. For example, if a passive fund replicates an equity index, it will be taxed like any equity-oriented fund.

Market growth and investor adoption

Over the past few years, passive funds have experienced remarkable growth in India. The AUM (assets under management) of passive funds stood at Rs 6.46 lakh crore as of November 2022, comprising 294 schemes (157 ETFs managing Rs 5.22 lakh crore and 137 index funds with Rs 1.24 lakh crore). By November 2025, passive fund AUM had grown to Rs 14.07 lakh crore, marking a 111 per cent increase in just three years. This growth reflects increasing investor confidence in low-cost, systematic investing strategies.

Data from SPIVA India (2025) reveals that approximately 66 per cent of large-cap active funds underperformed their benchmarks over the past decade, making passive funds an increasingly attractive option for equity investors. Despite this growth, retail participation in passive funds remains modest at around 7.1% of total passive AUM, suggesting significant untapped potential among individual investors.

Choosing your passive investment

For index funds: Consider the expense ratio first. Because all index funds that replicate the same index have similar portfolios, their costs are a significant differentiator because they impact returns. An index fund with a lower expense ratio than others tracking the same index will return more. Also, analyse the tracking error: the lower the tracking error, the better the index fund.

For ETFs: Besides expense ratio and tracking error, consider two additional factors: (a) the difference between the traded price of the ETF on the exchange and its NAV, and (b) liquidity. Check how frequently the ETF trades on the stock exchange. If you buy an ETF with a lower trading volume (liquidity), it will be difficult for you to sell it.

Direct vs regular plans: Direct plans charge lower expense ratios than regular plans because no commissions are paid to intermediaries. This difference compounds significantly over long-term investments.

Should you invest in passive funds?

Investing in funds tracking a broader market index like the Nifty or Sensex makes sense for conservative investors who do not aspire to earn more than the market index. If you are someone who yearns to earn more over longer periods, actively managed schemes should be your option. Investing in FoFs makes sense only if the underlying fund is otherwise not available easily to you, such as FoFs investing in foreign mutual fund schemes or indices like the NASDAQ.

For first-time investors and those seeking a stress-free, low-cost approach, passive funds present a compelling case. This video provides further insights into building a passive portfolio. Understanding how index funds track the market is also crucial before you start investing.

Which passive mutual funds are right for you?

To find out which passive funds you should invest in, subscribe to Value Research Fund Advisor. Here, you can get access to our list of analyst-recommended funds and a customised list of mutual funds that are aligned with your financial needs.

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This article was originally published on July 26, 2023, and last updated on February 02, 2026.