For quite some time, there is a debate going on between active mutual fund schemes and passive ones. There is a shift happening in favour of passive funds. The argument is that actively managed funds charge a relatively higher expense ratio to the fund. If a fund is not performing better than the benchmark index, then the management cost is not justified. The investor would rather buy the reference index — not literally, but through a passive fund. This article is not about that debate as to which one is better. This is about sensitisation on certain concepts relevant to investment in passive funds.

Return expectation

To be noted, a passively managed fund would never perform better than the reference index, as it will simply track it. Rather, returns from passive funds would be marginally lower than the reference benchmark index.

This is due to three reasons: First, there would be expenses charged to the fund: though much lower than active ones, it would make your returns that much lower than the index. Secondly, there would be a tracking error, impacting your returns;

Thirdly, if it is an usual open-ended fund where purchase-redemption is available with the mutual fund, and not an exchange traded fund (ETF), there would be a small cash component in the fund to meet redemptions. When the market is booming, this component would yield relatively less than the reference index.

Tracking error

In a passive fund, the mandate of the fund is to follow the index i.e. construct a portfolio that replicates the reference benchmark index. As an example, if it is Nifty50 or Sensex, the passive fund will buy the same stocks as in the index, in the same proportion. However, small deviations do happen. There is a metric called tracking error, which looks at the extent to which returns have deviated from the benchmark index. Obviously, the lower the tracking error, the better. To get the basics of what is tracking error, (1) it measures to what extent the returns of your fund has deviated from the underlying index and (2) statistically, tracking error is defined as the annualised standard deviation of the difference in returns between the index fund and its corresponding index.

Since it is standard deviation, the output is a positive number. Lower the number, better for you as an investor as it indicates your fund is tracking the index that much closely. An index fund manager needs to calculate his/her tracking error on a daily basis, especially if it is an open-ended fund with daily purchase / redemptions and need to re-adjust the portfolio.

If you want to know, over a period of time, to what extent returns from your fund is lower than the index, you simply have to compare the returns. As an example, if the index has delivered 10% over your investment period and the fund has yielded 9.9%, then 0.1% is the tracking difference. To be noted, tracking difference is a simple measure, just the difference in returns, which you can calculate. Tracking error is a statistical measure calculated and disseminated by the mutual fund.

Fund format

There are exchange traded dunds (ETFs) that are listed at the exchange i.e. NSE/BSE. Post the new fund offer (NFO) period, you can purchase an ETF only at the exchange, and not from the mutual fund. When you want to sell it off, you can sell only at the exchange. You require a demat account and a trading account with a stock broker, for purchase/sale. These days, it can be done seamlessly, online. Only that, when you want to sell, there should be buyers at the exchange, otherwise you will have to suffer on the price.

What you have to be mindful of in an ETF is, the price at which you buy or sell would be different from the NAV of the fund. For the quoted or traded price at the exchange, while the NAV is the reference point, there may be significant differences as people are free to buy-sell at any price.

Then there are funds, not ETFs, which follow the relevant index and you can purchase/redeem with the mutual fund. You do not require any trading account with a stock broker, and demat account is not compulsory. In this format, liquidity is better for you, as you can redeem with the mutual fund anytime you want, at the NAV.

Fund selection

Usually, we select funds with performance as one of the criteria. In passive funds, performance as such is not a criterion. A passive fund is meant to just follow the index and the fund manager does not take any independent decision in managing the portfolio. Rather, to evaluate passive funds, you look at tracking error or tracking difference. Tracking is the gauge of efficiency for passive funds — how closely it is tracking the index, what it is supposed to do.

For ETFs, you may check liquidity at the exchange, that will give you a clue that when you want to sell, what the situation might be. For the ‘normal’ funds, ones you buy/sell with the MF, you may refer to fund corpus size. That gives you a clue, how many investors have reposed their faith in that fund, and if there is a sudden redemption pressure, how comfortable they may be to create that much liquidity.

Index selection

This is the crux of it. Selection between one passive fund and another can only make a marginal difference to your returns. The index you select will make a bigger difference. There is no one-line answer as to which index would give higher returns or which index is better for you. This is an area where you would do better to seek professional advice, from an advisor.

(The writer is a corporate trainer - financial markets - and author)