Use passive funds in portfolio for broad-based, low-cost, stable allocation

Avoid need to chop and change funds due to underperformance; supplement with active funds in satellite portion

For the first time in September 2025, net new folio additions in passive mutual fund schemes surpassed those in active equity schemes. Passive schemes — spanning index funds, exchange-traded funds (ETFs) and fund-of-funds (FoFs) — added 2.1 million accounts, compared with 1.4 million new accounts in active equity funds. 

Key drivers: Precious metal ETFs 

Precious-metal ETFs were the main catalyst. “Passive schemes added a record number of folios in September, driven by gold and silver ETFs,” says Siddharth Srivastava, head – ETF product & fund manager, Mirae Asset Investment Managers (India).

 

Gold and silver funds, which have returned 56-69 per cent year-to-date (YTD), attracted strong interest. “Returns of precious metals led to momentum chasing and created FOMO (fear of missing out) among investors, driving inflows,” says Satish Dondapati, ETF fund manager, Kotak Mutual Fund. 

“Global wars and the tariff crisis highlighted the importance of gold as a safe haven, creating strong demand from central banks. Silver benefited from a global demand-supply gap and industrial use,” says Vikash Wadekar, head – passive business, Axis Asset Management Company.

 

Long-term picks 

Passive funds appeal to investors seeking to avoid the risk of underperformance by the fund manager and minimise the need for frequent chopping and changing of  funds. “Investors recognise their structural strengths: consistency, transparency, and diversification,” says Chintan Haria, principal – investment strategy, ICICI Prudential Mutual Fund.

 

Dondapati adds that lower cost allows more of the investment to stay invested and compound.

 

Forgo market-beating returns

 

Passive funds cannot generate alpha as they only mirror the index. The lack of fund manager discretion means they cannot avoid certain risks. “They cannot avoid overvalued or risky segments,” says Aparna Shanker, chief investment officer – equity, The Wealth Company Mutual Fund.

 

Market-cap-weighted indices can become dominated by a few large companies, increasing concentration risk. Shanker adds that passive funds also miss opportunities in emerging sectors that are yet to gain significant weight in the index.

 

Tracking error can exacerbate underperformance. Srivastava highlights that exotic products may add additional layers of risk. ETF investors must also monitor liquidity and spreads.

 

Role in core and satellite portfolio 

With the passive universe expanding, these funds can be used in both core and satellite allocations. “Asset allocation becomes easier, given the availability of a wide selection of passive schemes: equity, debt, thematic and smart-beta strategies,” says Haria.

 

“Passive funds tracking broad-based, market-cap-weighted indices (e.g., Nifty 50, Midcap 150, Nifty 500) can anchor the core by offering stable, low-cost, benchmark-like returns. Thematic, sectoral, smart-beta and commodity passive funds (e.g., gold or silver ETFs) can be used in the satellite to capture cyclical opportunities or express conviction-based views,” says Srivastava. According to Wadekar, investors with a trading mindset may prefer passive funds in the satellite or short-term trading segment.

 

Views differ on the appropriate market-cap segments for passive investing. “Passive exposure can be considered in large-caps, where markets are relatively efficient and information is well-priced. Mid- and small-cap segments offer inefficiencies where active management continues to add significant value,” says Shanker.

 

Wadekar supports passive exposure across all segments, arguing that after Sebi’s fund categorisation, beating indices has become more challenging for active funds in every segment due to growing market efficiency.

 

Smart-beta funds: Weigh pros and cons 

Smart-beta funds track indices that select and weight stocks based on factors like value, quality, momentum, low volatility, alpha, and dividends. “They use rule-based or factor-based strategies to get an edge over purely market-cap-weighted indices,” says Aditya Agarwal, co-founder, Wealthy.

 

“Rules-based processes reduce manager discretion and behavioural risk,” says Chirag Doshi, chief investment officer of fixed income assets, LGT Wealth India. Their costs, however, are higher than those of market-cap-weighted indices. Doshi adds that factor strategies may underperform when the chosen style falls out of favour.

 

“Their risk-adjusted performance has been modest, with higher volatility. They tend to be less efficient compared to active diversified equity funds,” says Feroze Azeez, joint chief executive officer (CEO), Anand Rathi Wealth. Azeez adds that the category is still new, with limited experience available across market cycles to assess long-term reliability. Agarwal considers smart-beta funds better suited to the satellite portion of a portfolio.

 

Should you use passive debt funds?

 

Passive funds, such as target maturity funds (TMFs) and others tracking gilt, PSU bonds, etc. are now available in the fixed-income segment as well. “They offer the benefit of low cost and rules-based exposure to sovereign and high-quality corporate bonds,” says Doshi.

 

“Target maturity funds offer predictable returns when aligned with the investor’s horizon,” says Agarwal. Most indices tend to hold high-quality bonds and hence carry low credit risk.

 

Azeez points out that TMFs have their limitations: interest-rate risk for those exiting before maturity, reinvestment risk after maturity, and lower tax efficiency for investors in higher slabs.

 

Agarwal points out that investors must watch out for all the usual risks present in debt funds even in passives: credit, interest-rate, and liquidity risk. He points out that liquidity risk is especially high in low-volume bond ETFs, where redemptions may be difficult.

Doshi points to the lack of flexibility for curve-timing or issuer selection when markets move quickly. “Hidden costs such as tracking error, cash drag and rebalancing may reduce net returns,” he says.

 

He recommends using passive funds for core fixed-income exposure to sovereign and top-tier corporate bonds, paired with active strategies for specific credit or interest-rate calls. Azeez adds that arbitrage funds may be more suitable for investors in higher tax brackets because of equity-style taxation.

 

Key criteria for selection

 

Index fund

 

*  Assess the underlying index — its purpose, composition and suitability for your goals and risk appetite

  *  Compare funds based on AUM (higher AUM generally provides better scale, liquidity and lower tracking error)

  *  Focus on net return after all costs, not just the headline expense ratio and tracking error

  *  Go for fund house with execution strength

  ETFs (additional criteria)

 

·       Assess liquidity through trading volumes and bid–ask spreads

 

·       Assess liquidity of underlying securities in bond ETFs