Think index funds are foolproof? These 7 myths can lead to costly mistakes
Passive investing has become mainstream in India, but several myths persist. Investors should not judge passive funds solely by low costs, assume they are risk-free, or treat them as “buy and forget” products. Choosing the right index, understandi...
Passive investing in India has now become mainstream. The total assets under management (AUM) across 690 existing passive funds are nearly Rs.15 trillion— almost a fifth of the total mutual fund assets in the country. Five years ago, there were only 160-odd passive funds running a little over Rs.3 trillion in AUM. Investors have clearly grasped the proposition behind passive investing—it is very difficult to consistently generate market-beating returns, as the market (index) itself runs efficiently in the long run. Instead of trying to beat the index by picking stocks, passive investing simply involves mirroring the index. Index funds and exchange-traded funds (ETFs) are the two vehicles that let you invest passively.
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:
Myth 1
The cheapest passive fund is the best
Low costs of passive funds are a big draw for many investors. In some index funds, expense ratios charged are as low as 0.05-0.1%, while some ETFs are even cheaper at just 0.02- 0.05% per annum. Investors often take comfort in funds with lower fees, expecting better tracking with the underlying index. However, lower costs in passive funds don’t always correlate with lower tracking error. Tracking error refers to the volatility of the difference between a fund’s return and that of its underlying index. It measures how consistently a fund follows its index. A marginally cheaper fund can still deliver worse outcomes if it tracks the index poorly.
Within passive funds, some even prefer ETFs for lower costs. However, this approach overlooks the associated costs of ETFs beyond the visible expense ratio. ETFs are bought and sold on the stock exchanges. ETF trading volumes vary widely, which affects liquidity and, therefore, the ability to buy or sell at the desired price and time. Arun Sundaresan, Head ETF, Nippon Life India Asset Management, explains that when investing in ETFs, investors should look at volumes at the stock exchanges (higher the better), impact cost (lower the better), tracking error (again, lower the better) and expense ratio. “All these are related. A higher impact cost, which may be a result of lower volumes, will have a direct bearing on the total cost of investing, often much higher than the expense ratio of funds,” he says.
Passive investing enters mainstream
Myth 2
Passive funds are only for beginners This narrative has been spun by some within the industry. By nature, passive investing is a simple pursuit, offering returns in line with the market. The argument goes that it is a great starting point for new investors to understand how the market works. Once they gain enough experience with market volatility and build decent assets, they can pursue more rewarding actively managed strategies.
This is not necessarily true for everyone. For some, passive investing may be the better choice even in later years. Likewise, even savvy investors may invest selectively in passive strategies to complement their existing portfolio. Sundaresan observes, “Passive funds are preferred by investors who seek market/index returns without the risk of choosing an active fund that may potentially underperform the market. These funds would be suitable not only for beginners but also for experienced investors for asset allocation and tactical portfolio positioning.” Siddharth Srivastava, Head – ETF Product & Fund Manager, Mirae Asset Mutual Fund, maintains, “With product innovation happening across size-segments, themes, sectors and strategies, passive products are now useful in any investor portfolio for a variety of investment objectives and investment horizons.”
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Myth 3
Passive investing is ‘buy and forget’ The advantage of pursuing passive investing is that investors do not have to worry about underperformance, fund manager exits or changes in investing style. This means investors don’t have to monitor the fund as closely as active strategies. However, its simplicity should not lull you into complacency. Passive investing does not mean you can “fill it, shut it, forget it”.
Passive funds definitely reduce the need for active monitoring or switching. But that does not eliminate the need for review, insists Ajay Kumar Yadav, Group CEO & CIO at Wise Finserv. “From time to time, investors need to check whether the index they are holding still fits their goal, risk appetite and overall portfolio mix.” Also, if the portfolio deviates significantly from the planned allocation, rebalancing becomes important, he adds. A simple review once or twice a year can help investors stay aligned with their original plan.
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Anil Ghelani, Senior Vice President, Head of Passive Investments & Products, DSP Mutual Fund, adds, “Just like we ensure a regular visit to our dentist for a general check-up, our investments are also best handled that way, whether it is passive funds or active.”
This is especially true if you invest in smart-beta index funds, which are curated around themes and can be quite cyclical, and cater to different risk profiles.
Passive investing is risk-free Passive investing does take away fund manager risk. This is the risk that the fund underperforms the market owing to wrong or mistimed bets. However, passive funds are still fully exposed to market risk—the risk of loss from a market correction. Further, a passive fund does not reduce exposure to an overvalued stock or dilute allocation to a heavily represented sector. It replicates all the risks that the specific underlying index is exposed to, including valuation risk, concentration risk, and so on. Ghelani points out, “In passive funds, we don’t take a fund manager view to override the rules of the index and its construction. However, other than that the market risk of equities will always remain.”
Yadav maintains, “If the index falls 20%, the passive fund will also fall broadly in line with the index. A passive fund will not move to cash, avoid expensive sectors, or reduce exposure during market stress. It will continue to mirror the index.” Srivastava observes that the segment or strategy that the index tracks defines its risk profile. “Depending upon the index method and its underlying portfolio, a particular passive product may be the riskiest, and another may be the least risky investment product in the MF industry,” he says.
Passive fund offerings are rising steadily Multiple indices won’t offer diversification Broad market indices tend to favour large-cap companies.
Myth 5
Fund selection matters more than index selection Every passive fund tracks a particular index. Currently, around 362 index funds track 171 indices, while 328 ETFs track 118 distinct indices, as per National Stock Exchange data. A common mistake is obsessing over which AMC offers the best index fund while ignoring the underlying index. Investors often start by asking “which is the best index fund?” Investors should start by asking “Which index is right for me?” Investors should first align index selection with their risk appetite and investment horizon.
Srivastava avers, “Different types of indices based even on the same segment or on the same strategy can generate very different returns and risk profiles depending upon their methodology, which can meaningfully vary. Whereas funds based on the same index will generate similar performance and differ in tracking efficiency, ETF liquidity, etc. Hence, a wrong index selection can impact you much more than picking the wrong fund from a pool of funds based on the same index.”
Once the right index is identified, focus on finding a fund that tracks it efficiently,at low cost, and with minimal tracking error. Nehal Mota, Co-Founder, Finnovate, remarks, “Choosing the appropriate index is the core investment decision, while choosing the best fund is the optimisation step that ensures you get the closest possible return to your chosen index.”
Myth 6
Buying more passive funds brings diversification 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. For instance, the constituents of the frontline Nifty 100 index are also well represented in the Nifty 500 index and the Nifty Total Market index. Since most indices are market-cap weighted, these allocate more money to already large companies. 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.
A simple, well-thought-out allocation to a few complementary indices is usually more effective than owning numerous similar funds. For example, a Nifty 50 index fund can be paired with a Nifty Next 50 index fund for material diversification.
Alternatively, the Nifty 500 Equal Weight index fund, with around 80% allocation to mid caps and small caps can meaningfully complement the Nifty 50 index fund. “Real diversification comes from spreading investments across different asset classes and market segments. If investors keep adding index funds without understanding what they actually own, they may end up holding the same stocks repeatedly through different funds,” Yadav warns.
Myth 7
ETFs are superior to index funds 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. ETFs usually have lower stated expense ratios than index mutual funds. 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.
However, investors ignore a few critical aspects. The expense ratio is only one part of the cost equation. Investing in ETFs has other accompanying costs, including brokerage charges and impact costs. Since ETFs are traded in real-time, the execution price may end up being higher (when buying) or lower (when selling) than the ideal price at the time you initiated the trade. This increases the transaction costs if the ETF is not very liquid. For small investors, these costs can offset the expense advantage. A well-run Nifty 50 index fund can outperform a poorly executed, lower-cost Nifty 50 ETF.
“ETFs offer real-time trading, but this benefit is useful only for investors who understand market price, liquidity, bid-ask spread and demat-based execution,” remarks Yadav. In some circumstances, ETF prices can stray far from the underlying net asset value (NAV), forcing investors to buy (or sell) at a sharp premium (or discount) to its real value. This happened recently in case of silver ETFs and a few international ETFs when prevailing curbs prevented creation of new units, resulting in ETF prices trading at a substantial premium.
Further, real-time trading in ETFs may give an illusion of control and offer a tactical edge over index funds, but it can also encourage harmful behaviour. A simple index fund’s end-of-day NAV often suits disciplined investors better, without worrying about exchange liquidity or trading spreads.
