Investing in passive mutual funds? Beware of these 7 misconceptions before investing

Even as passive investing has gained traction, many myths and misconceptions abound. These are harmful enough to lead you to wrong choices, unrealistic expectations and ultimately, disappointing outcomes. Here are a few such myths about passive investing, as reported by ETWealth.

Low costs of passive funds are a big draw for many investors. Investors often take comfort in funds with lower fees, expecting better tracking of the underlying index. However, lower costs in passive funds don’t always correlate with lower tracking error. A marginally cheaper fund can still deliver worse outcomes if it tracks the index poorly.

This perception has been promoted by some sections of the industry. Since passive investing is inherently simple and aims to mirror market returns, it is often presented as an ideal starting point for new investors to understand market movements and volatility. The idea is that once investors gain experience and build a sizeable corpus, they can gradually explore actively managed strategies that have the potential to generate higher returns.

Passive investing eliminates concerns such as fund manager changes, style drift, or underperformance versus the benchmark. However, despite its simplicity, investors should not adopt a completely hands-off approach and must review their investments periodically.

While passive funds eliminate fund manager risk, they remain fully exposed to market risks. They mirror the underlying index and therefore carry the same valuation, concentration, and sector-specific risks as the index itself.

Many investors focus on choosing the best index fund instead of the right index. The first step should be selecting an index that matches one's risk appetite and investment horizon, followed by choosing a low-cost fund with efficient tracking and minimal tracking error.

Investors often buy several index funds/ETFs, believing they are spreading risk widely. In reality, many passive funds repeatedly hold the same large-cap stocks, creating heavy overlap. As a result, portfolios can become overexposed to a handful of dominant stocks or sectors. Adding multiple passive funds can clutter portfolios without meaningfully improving returns or lowering risk. Investors may also unwittingly complicate asset allocation.

Within passive investing, investors can choose between index funds and ETFs. While both do the same job—mimicking the underlying index—they often differ in cost, liquidity, and tracking error. Since passive investing is about minimising costs, investors conclude ETFs will always win. Furthermore, ETFs offer real-time trading, so investors consider them more efficient and liquid.