Asset allocation can be best implemented using passive ETFs or index funds

Asset allocation can be best implemented using passive ETFs or index funds
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If you are a beginner and wondering how to invest in the stock markets, then you can consider passive investing, which can be done either through exchange-traded funds (ETFs) or index funds. These funds track the index of the market or sectors where they are invested. They are not linked to any single stock, instead, their underlying asset is the benchmark index such as Nifty or Sensex. Moreover, the underperformance of active funds versus their respective benchmarks indicates how hard it has become for an active fund manager to deliver alpha, especially in the large-cap space. If you don’t already have exposure to passive funds, experts say to consider allocating some part of your large-cap portfolio to passive funds.

In the case of active funds, fund managers are supposed to pick the stock from the benchmark. There is no compulsion of picking it up in the same allocation. However, fund managers of passive funds generally have very less or negligible doing in managing the funds. Their effective management can be evaluated by their tracking error. The closer it is to zero, the better it will be.

Active funds are comparatively expensive when it comes to the cost due to their high expense ratio which is nothing but the fee we pay to the fund manager for managing the scheme. On the other hand, passive funds are cheaper due to very little management by the fund manager.

Vishal Jain, Head ETF, Nippon Life India Asset Management Ltd. “At the outset, it should be highlighted that asset allocation is the prime driver of returns and this is confirmed by various studies. Some studies point out that more than 95% of investment outcomes are due to asset allocation and a miniscule component is because of security selection or market timing. Indexes are portfolios that mimic the behaviour, properties and characteristics of an asset class. In that sense, they represent an asset class or its sub-categories like sectors, market cap and so on. Asset allocation can be best implemented using passive ETFs or index funds. Currently, a wide variety of low-cost passive products are available for portfolio construction covering equities, sectors, themes, fixed income and gold.”

Jashan Arora, director, Master Capital Services, said “The introduction of TRI (Total Returns Index) has played a vital role in filling up the gap between the fund returns and their indices. It’s important to understand that there can be multiple reasons for the active funds to fail to match the performance of their respective indices. For instance, fund manager of a large-cap scheme is mandatorily bound to invest at least 80% of its assets in the top 100 companies as per their market capitalisation which gives him very little space to take advantage of opportunities available in the respective indices. Similarly, other categories have their own restrictions of selecting the securities from their benchmark. Unlike active funds, passive funds such as index funds or ETFs try to replicate the exact composition of their respective benchmark which is missing in the case of Active Funds.”

Cost of Index and Exchange Traded Funds

Generally, the average cost of investing in ETFs or Index Funds is 0.5%-0.10% with a maximum capping of 1%. Active funds have an expense ratio of 1% to 2.5%.

Jain said, “Passive funds by definition are low cost because there are no expenses involved such as fund management and research. Low TERs, therefore, put more money in the investor’s pocket.”

He further added, to illustrate let us consider a simple example, assume a fund linked to the Nifty Index gives around a gross CAGR of 15% over 5 years, an actively managed fund too has given a similar gross return. The passive index fund or ETF will give a much higher net return to an investor because its expense ratios are significantly lower than the actively managed fund. Hence the index fund / ETF investor will end with a larger corpus simply because the dictum of ‘a penny saved is a penny earned’ worked in his favour.

Neelabh Sanyal, COO & Co-founder, Kuvera, an online investing said “Returns already factor in the cost of investing whether passive or active funds since they are based on NAV on purchase date vs current NAV. So rather than evaluate on the basis of returns plus cost investors would do well to think of passive as a long-term investing strategy. The lower cost of passive funds is an added advantage.”


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