Passive investing is all about taking an index approach rather than being active in the stock markets. In fact, there are four ways of creating a passive investment strategy in the Indian context…

· An equity investor can create a passive strategy by buying up all the index stocks in the same proportion as the index. But for an individual that can be quite complicated as he will have to track index changes, weightage changes etc.

· A simpler way to replicate the above will be to directly buy an index fund, which is offered by many mutual funds in India. An index fund buys up the entire index in the same proportion. The fund manager manages the tracking error and ensures that the fund performance is as closely aligned to the index as possible. Index funds can be bought from the mutual fund houses, from distributors or even online.

· ETFs are a slight variation of the index fund. Like an index fund, the ETF also creates a portfolio of index stocks in the same proportion. The only difference is that the ETF is listed on a stock exchange and can be bought and sold on any recognized stock exchange. Additionally, ETFs are also available on other benchmarks like ETFs on gold, ETFs on silver, ETFs on equity indices, ETFs on debt market indices etc.

· There is a slight variation of passive investing which entails buying and holding a portfolio of dividend yield stocks. Dividends are tax-free in the hands of the investor up to a limit of Rs.1 million per year. Thus a stock that offers a dividend yield of 6% will actually be paying a effective tax- adjusted return of {6%/(1-0.3)} = 8.57%

Let us now look at when does passive investing approach make more sense?

Actually, just as active is an approach that works, so also does active. It is hard to pinpoint factors that will make passive investing attractive. But here are 5 situations that can be specifically conducive for passive investing…

· Passive strategies work well when the markets are extremely volatile. In such situations, stock specific strategies are fraught with risk as the downside risk could be quite high. An indexing approach tends to mitigate this overall risk in investing. Passive can work better in such circumstances.

· Passive works better when the markets are being increasingly driven by macro factors and less by micro factors. Take the case of a situation when there are major macro risks to the market like war, interest rate hikes, spike in inflation etc. In such circumstances, the macros will become more important than micros and a passive strategy will work better.

· When most stocks are either fully priced or overpriced in historical terms, a passive strategy works better. In this kind of situation, identifying stocks which can really give you excess returns is very difficult. You will be better off sticking to an index fund since you get the benefit of equities without taking stock-specific risk.

· When the incremental returns on active funds is very small. For example if index funds are giving 12% and active funds are giving 16%, then there is a case for active funds. But if the active fund in the above case is just giving 13%, then the higher cost and risk is not justified by 1% additional returns. You are better off with passive investing.

· Lastly, when the equity market is more about risk minimization rather than about return maximization. When markets are at their bottom, the focus will be on maximising returns. However, when the markets are at the peak or when they are lacklustre, the focus should be on minimizing risk. In such cases, passive investing is a much better strategy.