What is a passive fund?

A passive fund tracks an index. It holds what the index holds, in the weights the index specifies, and it does not try to do better. Its job is to deliver the index return minus a small and predictable cost. Understanding it properly means understanding what the index does, because in a passive fund the index makes every decision.

How tracking works

Most Indian index funds use full replication, holding every constituent in its index weight. Where an index contains illiquid or hard to access constituents, a fund may use sampling, holding a representative subset chosen to behave like the whole.

The fund must also handle events the index handles: constituents entering and leaving at each review, corporate actions, dividends, and inflows and redemptions that arrive on days the index does not care about. Doing all that cheaply and accurately is the entire skill in passive management, and it is real skill even though it is not stock selection.

Two different words that get used interchangeably, and should not be

Tracking error

Tracking error measures how much the fund's returns vary from the index's returns. It is a measure of consistency. A high tracking error means the fund's deviation from the index is erratic, sometimes ahead and sometimes behind.

Tracking difference

Tracking difference is the actual gap between the fund's return and the index's return over a period. This is the number that affects what you receive.

A fund can have low tracking error and still trail the index steadily, if it lags by a similar amount every period. Expenses guarantee some lag, because the index has no costs and the fund does. When you compare passive funds on the same index, look at the tracking difference over several periods, and expect it to be roughly the expense ratio plus a little.

The index is doing the work, so read the index

Most broad Indian indices weight constituents by free float market capitalisation, so the largest companies by market value carry the largest weights. Constituents are reviewed periodically and changed by rule rather than judgement.

Two consequences follow, and both are frequently misunderstood.

• A passive fund is only as diversified as its index. If a handful of companies or one or two sectors dominate the index, they dominate your holding. Nobody decided that, which does not make it any less true
• A passive fund buys what has risen and sells what has fallen, because weights follow market value. That is a feature of the method, not a flaw, but it is not the same as buying cheaply

What is available in India

• Broad market index funds and exchange traded funds on indices such as the Nifty 50 and the Sensex
• Wider market indices covering the next tier of companies, and mid and small cap indices
• Sectoral and thematic indices, which are narrow by design and therefore concentrated
• Factor or smart beta indices, which select and weight by rules other than market capitalisation, such as low volatility, quality or momentum
• Debt index funds and target maturity funds, which track bond indices with a defined maturity
• Commodity exchange traded funds, principally gold and silver

A factor index fund is worth thinking about carefully. It is passive in that it follows rules mechanically, and it is a departure from the market in that the rules were designed by someone with a view. Passive is not automatically the same as neutral.

What passive does not do

• It does not protect you in a falling market. It follows the index down, in full
• It does not diversify away concentration that exists in the index
• It does not remove the need to choose, since choosing an index is a choice
• It does not guarantee lower cost, because a narrow or specialised passive fund can cost more than a broad one

Tax treatment is about the holding, not the label

Nothing in tax law recognises passive management. Treatment depends on what the fund holds. A passive fund with more than 65 per cent in domestic equity is taxed as an equity-oriented fund, exactly as an active fund with the same composition would be. A passive fund with more than 65 per cent in debt and money market instruments falls under the specified mutual fund rules and is taxed accordingly.

So check the composition, not the management style, when you want to know how a gain will be taxed.