When it comes to investing in equity markets, retail investors often look at the movements of the benchmark indices - NSE Nifty 50, S&P BSE Sensex BSE 200, BSE Midcap Index, BSE Small Cap Index, Nifty 500, etc. This is because such indices may be considered indicators of financial markets.
Not everyone may discuss or review their specific stock picks. Some investors may prefer to track benchmark indices to gauge market sentiments. This is because an investor may be likelier to know the broader market trend in the benchmark indices than the movements in each listed stock.
One may know how the broader market has performed over the past week, month or year. However, one may not understand the specific movements in the stocks forming part of such indices over the same period. Therefore, one may prefer investing in such indices directly to simplify their investing.
However, since the indices are not listed securities, one cannot invest in benchmark indices, say NSE Nifty50 or S&P BSE Sensex, etc. This is where passive funds pose as a suitable investment instrument.
Before discussing passive funds, it is important to understand the investing context for such funds. While investing, one can adopt either an active or a passive investment strategy.
While active investing requires an active selection of securities for the investment portfolio, passive investing refers to tracking the underlying benchmark index/commodity and replicating the same in the investment portfolio in its entirety.
In passive investing, fund managers do not enjoy any flexibility to invest beyond the index constituents or deviate from the index weights. Examples of passive funds include index funds, exchange-traded funds, fund of funds, etc.
Here are some essential pointers to note about passive funds:
Investment portfolio
As per SEBI (Securities and Exchange Board of India) Guidelines, passive funds (index funds/ ETFs) should invest at least 95% of their total assets in the underlying index's securities. As such, passive funds construct an investment portfolio similar to the constitution of a benchmark index, while maintaining liquidity to manage redemption requests.
The weightage of the index constituents must be the same in the investment portfolio as in the benchmark index itself. Changes in the index composition must be replicated in the investment portfolio too.
Elimination of unsystematic risks
To mitigate investment risks, investors must first understand them. There are two types of investment risks - systematic and unsystematic.
Systematic risk refers to unfavourable market events adversely impacting the investment portfolio, considered imperative to all market-linked investments. On the other hand, the unsystematic risk may be specific to a particular sector or company. Since passive funds don't allow investment beyond the underlying index, unsystematic risks may get automatically eliminated.
Cost-effective investment option
Due to the limited role of fund managers and lower costs in stock selection or research, such funds may carry lower charges. As such, passive funds provide an alternative low-cost investment option with exposure to the underlying index.
Returns from passive funds
Since there is no deviation within the investment portfolio of passive funds against the index constitution, such funds will tend to have zero alpha, i.e. variance in investment performance from the benchmark indices.
However, since benchmark indices are constructed using time-tested methodologies, the investors may still be comfortable mirroring the benchmark returns instead of aiming to outperform them.
For example, assume that NSE Nifty50 has generated 9% returns during the past 12 months. Then passive funds tracking the index also generate approximately 9% returns, subject to scheme expenses and tracking errors.
How to invest in passive funds?
The investing process for index funds is similar to investing in other mutual fund schemes. Thus, investors may invest through physical submission of the application forms or by undertaking the transaction through digital means, i.e., through the website/mobile apps of the mutual fund house or Registrar and Transfer Agent (R&TA).
Taxation of passive funds
Since passive funds replicate the benchmark indices, the taxation will depend upon the composition of the underlying index. Passive funds replicating equity indices are taxed as equity- oriented funds, while those replicating other indices like debt indices, commodity indices, etc., are taxed as non-equity oriented funds.
Gains from investments in mutual funds are classified as Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG), depending upon the holding period of such investments. The equity funds’ holding period for STCG is 12 months, while for other funds, including debt funds, the specified cut-off period is 36 months. After this period, the gains will be classified under LTCG.
The tax rate for STCG from equity-oriented funds is 15%, while the tax rate for LTCG is 10% without indexation benefit. Additionally, LTCG from equity shares and equity funds of ₹1 lakh in aggregate every year are taxed at a zero rate. In contrast, STCG from non-equity oriented funds are taxed at regular tax rates applicable to the investor, while LTCG from debt funds are taxed at 20% with indexation benefit.
Passive funds emerge as an attractive investment option for investors who seek exposure towards the benchmark indices instead of relying upon the fund managers' selection of stocks.
Note: The tax provisions, as mentioned in the article, are for illustrative purposes only and are updated as per the Union Budget 2022 presented in the Parliament in February 2022. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the date of investment.
Disclaimer-
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
To know about the KYC documentary requirements and procedure for change of address, phone number, bank details, etc. please visit https://www.utimf.com/servicerequest/kyc. Please deal with only registered Mutual funds, details of which can be verified on the SEBI website under "Intermediaries/market Infrastructure Institutions" All complaints regarding UTI Mutual Fund can be directed towards service@uti.co.in and/or visit www.scores.gov.in (SEBI SCORES portal). This material is part of Investor Education and awareness initiative of UTI Mutual Fund.
