For decades, the goal of a fund manager was to "beat the market." If the Nifty 50 index went up by 10%, the manager tried to deliver 12%. This is called Active Management. However, as markets become more efficient, beating the index is getting harder and more expensive.

Enter Passive Investing. Instead of trying to beat the index, passive funds simply try to copy it. If the index goes up 10%, your fund goes up 10%. This simple shift has changed the world of finance by drastically lowering costs for investors.

1. What are Index Funds?

An Index Fund is a mutual fund that tracks a specific stock market index, like the Nifty 50 or Sensex. The fund manager does not pick stocks based on research; they simply buy the same stocks in the same proportion as the index.

Example: If HDFC Bank has a 10% weightage in the Nifty 50, a Nifty Index Fund will put 10% of its money into HDFC Bank. No questions asked.

Advantages of Index Funds:

  • Lower Costs: Since there is no expensive research team or star fund manager to pay, the fees (Expense Ratio) are much lower—often 0.1% to 0.3% compared to 1-2% for active funds.
  • No Manager Risk: You don't have to worry about a fund manager making a wrong bet or leaving the company.
  • Simplicity: You are investing in the "Market" itself. As the economy grows, the top companies grow, and so does your wealth.

2. What are ETFs (Exchange Traded Funds)?

An ETF is very similar to an Index Fund—it also tracks an index. However, the way you buy and sell it is different. While an Index Fund is bought from a Mutual Fund House, an ETF is traded on the Stock Exchange just like a regular share.

Index Funds
Bought/Sold via Mutual Fund Apps.
Demat account not mandatory.
Orders processed at end-of-day NAV.
SIPs are very easy to set up.
ETFs
Bought/Sold on NSE/BSE via a Broker.
Requires a Demat & Trading account.
Price changes every second (Real-time).
Involves brokerage & STT costs.

3. Key Concepts to Know

A. Expense Ratio

The "cost of ownership." Because passive funds require less work, their expense ratios are significantly lower. Over 20 years, the difference between a 0.2% fee and a 1.5% fee can result in lakhs of rupees in extra savings for you.

B. Tracking Error

In a perfect world, if the Nifty 50 returns 10.0%, the index fund should return 10.0%. But because of fund expenses and the time it takes to buy stocks, the return might be 9.8%. This difference (0.2%) is called the Tracking Error.
Rule of thumb: The lower the tracking error, the better the fund.

C. Liquidity (For ETFs)

Since ETFs trade on the exchange, you need someone to buy from you when you want to sell. For popular ETFs like "Nifty BeES," this is easy. For obscure or small ETFs, you might struggle to sell your units at the right price.

4. Passive vs. Active: The Debate

Should you only invest in Passive Funds? Not necessarily. Here is the general consensus in the Indian market:

  • Large Cap: High efficiency. Most active managers struggle to beat the Nifty 50. Passive is often better here.
  • Mid & Small Cap: These stocks are less researched. Active managers can still find "hidden gems" and beat the index. Active might still have an edge here.
Smart Investor Strategy: Many investors use a Core & Satellite approach. They keep 60-70% of their money in low-cost Index Funds (Core) and 30% in high-conviction Active Funds or Sector Funds (Satellite) to try and boost returns.

Summary

Index Funds and ETFs are the best friends of the "set it and forget it" investor. They provide broad market exposure at the lowest possible cost. If you don't want to spend time analyzing which fund manager is the best, just "buy the market."

But how do you know if a fund—active or passive—is actually doing a good job? In the next module, we will learn the metrics used for Analyzing and Comparing Funds.