Passive funds are ideal for investors looking for a low-cost way to invest in mutual funds. For those who don’t know: Mutual funds can be divided into two broad categories: actively managed funds and passively managed funds. Most people are familiar with active funds and how they work. Active funds have dedicated portfolio managers who actively make investment decisions and decide what actions to take to build a profitable portfolio.
But in the case of passive funds, they constantly track the market index and try to generate similar returns, keeping tracking errors to a minimum. While active funds constantly try to outperform their underlying benchmark and generate high returns, index funds are designed to generate returns similar to those of the index they track.
Index funds are passive investment funds that invest the majority of their investable capital in the underlying securities that make up the benchmark, in the same proportion, without changing the composition of the portfolio. The performance of an index fund depends entirely on how the underlying securities that make up the benchmark perform over different market cycles.
Managers of index funds ensure that the composition of the fund’s portfolio remains similar to that of the index. If changes are made to the index securities, the fund manager should ensure that these changes are also made to the index fund portfolio in order to minimize tracking error.