Passive investing gains ground: What’s driving the shift to index funds and ETFs?

Are investors increasingly using passive funds to achieve their financial goals? Passive funds attracted ₹1.29 lakh crore in net inflows, including ₹1.07 lakh crore into Exchange Traded Funds (ETFs) and ₹22,395 crore into index funds in the year-to-date (YTD) 2026. Within ETFs, the Nifty/Sensex category attracted ₹61,054 crore, followed by Gold ( ₹39,475 crore) and Silver ( ₹11,211 crore).

Assets Under Management (AUM) of passive funds surged 24.4% year-on-year to ₹15.15 lakh crore at the end of July 2026, data with National Stock Exchange (NSE) showed. They now account for 18% of the overall AUM of the mutual fund industry. Index funds are not merely used to replicate markets, but to construct diversified portfolios aligned with long-term financial goals.

What is driving the increased interest in passive funds?

“Passive funds offer investors the flexibility to invest across a wide range of indices spanning different asset classes and investment themes,” said Diipesh Shah, Executive Director and Fund Manager, DSP Mutual Fund. “They are relatively low-cost in nature, making them an attractive choice for cost-conscious investors,” he said.

“The product range has also become much wider. Investors are no longer restricted to just the Nifty 50 or Sensex. They can now get passive exposure to large-caps, mid-caps, sectors, themes, factor strategies and international markets,” said Ajay Kumar Yadav, Group CEO and CIO, Wise Finserv, a financial services firm that offers financial planning and wealth management, among others.

NSE indices currently list more than 200 ETFs and index funds tracking Nifty indices in India, which shows how much the passive ecosystem has expanded. “Another reason is that investors are becoming more aware that consistently beating an index is not easy, particularly in large-cap stocks where information is widely available and companies are closely researched,” Yadav stated.

“So, for many investors, the thinking has changed from ‘Which fund will beat the market?’ to ‘Why not simply own the market at a low cost?” he said. “That does not mean active management is becoming irrelevant. It simply means investors now see passive funds as a serious part of the portfolio rather than just an alternative product,” he said.

“Passive funds are an easy way to gain diversified exposure to market indices without having to go to the trouble of picking the right fund manager themselves,” said Mukesh Pandey, MD and Founder, Rupyaapaisa.com, a financial consultancy. “Additionally, the advent of online investment platforms and the entry of young investors into the mutual fund world have further facilitated the process.”

Cost is another important factor. “Passive funds generally have lower expense ratios because the fund manager is not actively selecting stocks. Over a long investment period, even a small difference in annual cost can make a meaningful difference to the final corpus,” Yadav said.

Are passive funds catching up with actively managed funds in India?

Passive funds have done well vis-à-vis directly managed funds in developed markets. In India, however, actively managed equity funds continue to outperform their passive peers in most categories.

According to the latest available ‘SPIVA India Year 2025 Report’ that measures the performance of actively managed funds against their benchmarks over different timeframes, over 75% of large-cap active funds underperformed their benchmark. However, in the mid- and small-cap categories, fewer than 20% of active funds underperformed their respective benchmarks.

“This suggests that active fund management continues to have a stronger edge in the mid- and small-cap segments. This preference is also reflected in industry SIP (Systematic Investment Plan) flow trends,” Shah said. “Actively managed funds can retain their upper hand in relatively less efficient segments such as mid and small-caps, while good stock selection may result in creating alpha,” Pandey said.

“In large-caps, the case for passive investing is becoming much stronger. In mid and small-caps, active management can still add value because the universe is much wider, research coverage is uneven, and there are greater differences between good and weak businesses,” Yadav said.

The trend is already visible in developed markets. For instance, in the US, 79% of active large-cap equity funds underperformed the S&P 500 in 2025. “India may not follow exactly the same path, but the gap between active and passive investing is certainly narrowing. Investors still have to identify a capable fund manager and stay with that manager through periods of underperformance,” Yadav said.

How much should an investor allocate towards passive funds in their portfolio?

Though asset allocation is entirely a personal choice of the investor, passive funds should be an important part of the portfolio, according to experts. “One approach (that) investors may consider is the core-satellite strategy, which combines active and passive investments. Under this approach, the core portfolio can comprise actively managed funds with the objective of generating long-term alpha, while the satellite portfolio can include passive funds to gain exposure to broad market indices,” Shah said.

“Passive funds could be the base of the equity allocation for long-term investors, while the availability of actively managed funds could enable them to invest additionally if some opportunity for alpha arises,” Pandey said.

“For a beginner who wants a simple portfolio and does not want to keep reviewing fund managers, even a larger passive allocation can work well,” Yadav said. “On the other hand, an investor who understands active funds, has access to good research and is comfortable monitoring fund-manager performance may choose to keep a relatively larger active allocation,” he said.

What are the pros and cons of passively managed funds?

One of the biggest advantages of passive funds is that the cost of investment is lower compared to their actively managed peers. “Since the fund simply follows an index, there is less research and stock picking. This means lower expenses and better returns for the investor,” Yadav said. “Lower expenses create the opportunity for better compounding in the long run,” Pandey said.

Passive funds are also simple to understand and follow. Investors do not have to continuously worry about whether the fund manager has changed, whether the fund’s investment style has changed or whether it has fallen behind its peers. Transparency in investments is also a major advantage. If someone invests in a Nifty 50 index fund, the underlying portfolio is largely known because the fund is simply trying to replicate the index.

But passive funds also have their own disadvantages. The fund manager has no discretion to avoid an expensive or weak company simply because it is part of the index. If a stock has a large weight in the index, the passive fund will continue holding it as long as it remains part of that index.

“An index itself may become concentrated in a few large companies or sectors. Passive investing removes fund-manager risk, but it does not remove market risk or concentration risk,” Yadav stated. “They will never outperform the benchmark index if costs are taken into consideration and will suffer equally in case of market decline. Besides, market-cap-weighted indices can concentrate big amounts of cash in certain sectors or companies,” Pandey said.

Investors also have to contend with tracking error in passive funds. Investors should not assume that every index fund tracking the same index will deliver exactly the same return. “Expense ratio and tracking error matter. Tracking error measures how closely the fund actually follows its benchmark,” Yadav said.