Are Passive Funds the Better Choice in a Volatile Equity Market?

Unlike actively managed funds, which aim to outperform the market by selecting specific stocks, passive funds simply aim to match the returns of the index they track.

This makes them inherently less active in management, with minimal buying and selling within the portfolio. All they ought to do is simply replicate the respective underlying index they are mandated to follow.

As a result, they are less expensive in terms of their expense ratio compared to actively managed funds. The table below sums up the key differences between the two:

Over the past few years, passive funds have gained significant traction among investors. One of the primary reasons for the increasing interest in passive funds is the ease and convenience and investors are largely satisfied with index returns amidst a time when many actively managed funds have either struggled to consistently outperform the benchmark returns or produce alpha.

In a market where volatility has intensified (owing to geopolitical tensions such as Trump's protectionist trade policies, domestic economic uncertainties, and inflationary concerns), the underperformance leaves investors wondering whether the higher fees associated with active management are justified.

In contrast, the lower expense ratio of passive funds seems more affordable in an environment where not many active fund managers have been able to outperform the underlying benchmark index.

Passive funds are not subject to stock selection risks associated with a fund manager's possible behavioural bias or poor judgment. Since all passive funds track a specific index and behave similarly, investors also do not have to deal with the difficult chore of choosing the best mutual fund from the wide range of options available. This perhaps seems comforting during periods of market uncertainty.

As regards the point of diversification, several passive funds tracking the respective index are offering that benefit also available in actively managed funds. So, the risk associated with individual sectors or stock-specific calls is also mitigated and all that the investors have to deal with is the market-linked risk.

The inflow data from the Association of Mutual Funds in India (AMFI) provides clear evidence of the growing interest in passive funds.

As of January 31, 2025, the net Assets Under Management (AUM) for index funds and ETFs stand at Rs 2.76 trillion and Rs 7.62 trillion, respectively.

The share of passive funds has been steadily increasing, as seen in the graph below:

The rising popularity of passive funds can also be attributed to fund houses that have been increasingly launching new index funds.

According to the monthly data released by AMFI, new index funds were launched every month in FY 2024-25, with October recording the highest number at 17 launches.

Mutual fund houses have focused on expanding their product basket recognising what's in favour among investors.

Since mutual funds can launch only one active fund per category, they have strategically introduced different variants of passive funds in the race to garner more Assets Under Management (AUM).

However, are passive funds the best choice during volatile market conditions?

While passive funds have some merits, investing in them does not guarantee protection from market volatility.

Here are some limitations of index and ETF funds that you cannot overlook...

1. Possibility of Ignoring Stock Fundamentals and Quality

Passive funds primarily track the respective index. It ignores whether fundamentals---whether the stocks are fundamentally sound, the Price-to-Equity (PE) multiple it is trading at, the Price-to-Book value (P/Bv), revenue growth, profit growth over the last few years and so on.

When a stock's market capitalisation goes up, a passive fund is required to adjust weight to keep the tracking error very minimal. This has to be done regardless of whether the stock's fundamentals justify the higher valuation.

Conversely, if a company's market capitalisation declines, the weight in the index decreases. This prompts the fund manager to reduce the exposure to such companies, even if their long-term fundamentals are still strong.

This approach results in buying high and selling low, which contradicts the conventional investment wisdom of buying low and selling high.

In contrast, fund managers of actively managed funds can carefully assess stocks based on parameters such as profitability, revenues, and valuations before adding them to the portfolio.

2. Dependence on Past Winners

While this may seem like a safe investment strategy, it is essential to recognise that past winners would not necessarily be future winners. As you may know, past returns are not an indicator of future performance.

Market-leading stocks in passive funds may eventually face saturation in earnings growth, limiting their upside potential and constraining future returns.

On the other hand, actively managed funds have the flexibility to reduce exposure to slow-growth companies whose fundamentals have deteriorated and reallocate investments to those with promising prospects, with strong future potential, and may be offering high-growth opportunities and/or are undervalued stocks.

3. No Immunity Against Market Volatility

If the index tracked by a passive fund falls during a market downturn, the fund will mirror that decline.

While active funds, on the other hand by pursuing a sensible active strategy has enough flexibility to adjust holdings accordingly to mitigate losses.

Additionally, active fund managers can capitalise on market opportunities and identify undervalued opportunities that passive strategies may overlook.

4. Inability to Outperform the Market

Index funds and ETFs are designed to match the performance of the market or a specific index, not outperform it. This means they can't generate alpha (extra returns above the benchmark).

Active fund managers, on the other hand, could potentially outperform the market by making strategic investment decisions based on thorough research and analysis.

To Conclude...

While passive funds may offer index-linked returns and the benefit of lower expense ratios, they are not immune to market volatility.

Even though actively managed funds may face underperformance in the short to medium term, they could be the better choice for generating inflation-beating returns over the long term.

Carefully build a mutual fund portfolio comprising both active and passive funds if you wish to make the most of available investment options.

Choose mutual funds aligned with your risk profile, investment objectives, financial goals, and time in hand to achieve those goals.

Be thoughtful in your approach.

Happy investing!

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Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.

This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.