Here’s what you need to be mindful of while choosing passive index funds for your MF portfolio

Pick existing passive funds from your chosen category that have sufficiently large AUMs from a few large fund houses.

While I am a proponent of index funds to get large-cap exposure (read why here), it is also true that nowadays, passive investors are spoilt for choice as the number and variety of index funds in India have suddenly shot up.

And given the increased interest, asset management companies (AMCs) also don’t want to be left behind in this passive wave. They would want to gather as much assets under management (AUM) as possible; otherwise, competitors (other fund houses) are there to mop it up.

But as an investor, how should you navigate this space? How should you pick index funds if there are so many confusing choices?

In my view, there are just a few basic factors that you need to keep in mind while picking index funds for your portfolio.

Large-cap index funds are the most suitable category for most investors looking to start their own passive investments. One of the major reasons for taking a passive route to large-cap exposure is the consistent inability of most active large-cap funds to outperform the index. So, if you wish to take large-cap exposure, you can pick between Nifty50 or Sensex-based index funds.

Technically, even the Nifty Next50 index funds qualify as large-cap funds. But in reality, its risk-return profile is a lot more like that of mid-cap funds.

As for mid-cap or small-cap exposure, I think the active funds are still doing quite well compared to passive indices in this market segment. This might change in the future. But for now, if you are investing in this space, it is still okay to pick well-managed, proven active mid- and small-cap funds.

As for sectoral / thematic index funds, I don’t think these are needed. Most investors are better off investing in broad, diversified indices and don’t need to take sectoral bets.

In recent times, Factor Investing has also attracted many investors. If we look at the back-testing data, several factors seem to outperform and generate alpha over the plain vanilla index. But, in any given year, all factors will not work simultaneously. So maybe, at least hypothetically, there is a need to create a multi-factor portfolio to stabilise portfolio outcomes. This will help avoid being stuck with a single factor that continues to underperform. But all said and done, all these factor strategies are just based on back-tested data and, hence, lack a reliable and long track record. So, it is best to ignore these as well or limit the exposure to them.

Once you have chosen an index or two to invest in, the next question arises -- which scheme should you choose from the multiple AMC offerings based on the chosen index? That is to say, how to choose a Nifty50 Index Fund from among the 12 AMCs (say) that offer it. While the underlying portfolio of stocks is obviously the same, their expenses (or expense ratio) may vary for different reasons.

The lower the expense ratio, the better it is for you as an investor. But beware. Many times, AMCs launch new passive funds with extremely low expense ratios to attract cost-conscious passive investors. But once sufficient AUM is gathered, the AMC may increase the expenses if need be. So, it is best to pick existing passive funds from your chosen category that have sufficiently large AUMs from a few large fund houses. That way, the benefit of a large AUM and its cost-efficiencies can be passed on to the investors.

The job of an index fund (manager) is to simply replicate the portfolio of an underlying index. But there are various reasons (like impact costs, etc.) that make it difficult to achieve the replication.

So, if a fund manager is unable to properly replicate the index in a low-cost, low-impact manner, then the index fund’s returns may not be exactly the same as the index being replicated. And this is where you need to review the metrics of Tracking Errors and Tracking Differences.

The tracking difference is the percentage difference in returns between the index fund and its underlying index (on a total return index (TRI) basis) over a specified period. The tracking error, on the other hand, measures the extent to which the index fund’s returns deviate (annualised standard deviation of daily return differences) from the underlying index’s total returns. All AMCs offering passive instruments will regularly publish both of these figures on their websites. So for investors, the lower these figures are for the periods for which the schemes are being compared, the better it is.

Happy passive index fund picking!