Understanding the Rise of Index Funds & ETFs in India

The Indian investment landscape is undergoing a silent but significant revolution. For decades, actively managed mutual funds dominated investor portfolios, with fund managers striving to “beat the market.” However, the current market scenario reveals a clear paradigm shift towards passive investing, driven by the burgeoning popularity of index funds and Exchange Traded Funds (ETFs). These investment vehicles, designed to simply track a specific market index, are rapidly gaining traction, reshaping how Indians approach wealth creation.

The numbers speak for themselves. As of March 2025, the Assets Under Management (AUM) of passive mutual funds in India surged by a notable 21% year-on-year, reaching ₹11.13 lakh crore. Equity ETFs and index funds are at the forefront of this growth, with equity ETFs alone accounting for an average AUM of ₹6.28 lakh crore. This remarkable ascent is a testament to the compelling advantages these passive instruments offer.

Why the Shift? The Driving Forces Behind Passive Investing’s Growth

Several key factors are contributing to the increasing allure of index funds and ETFs in India:

• Cost-Effectiveness: This is arguably the most significant differentiator. Unlike actively managed funds that charge higher expense ratios to cover research, management, and frequent trading, index funds and ETFs are passively managed. They simply replicate an index, leading to significantly lower operational costs and, consequently, lower expense ratios for investors. These savings, compounded over the long term, can have a substantial impact on net returns.
• Diversification and Reduced Risk: Index funds and ETFs inherently offer broad market exposure. By investing in a basket of securities that mirrors a specific index (like the Nifty 50 or Sensex), investors automatically diversify their portfolios across various companies and sectors. This diversification mitigates the impact of poor performance from any single stock or industry, offering a more balanced approach to risk management compared to picking individual stocks or relying on a single active manager’s decisions.
• Simplicity and Transparency: For many retail investors, the world of stock picking and market timing can be daunting. Index funds and ETFs offer a straightforward and hassle-free way to participate in the stock market. There’s no need for extensive research or continuous monitoring of individual company performance. Furthermore, ETFs offer high transparency, with their underlying holdings published daily, allowing investors to know exactly what they own.
• Consistent Performance: While index funds do not aim to outperform the market, they reliably track its performance. Historical data consistently shows that major indices like the Nifty 50 have delivered attractive returns over the long term, mirroring India’s economic growth. By investing in an index fund, investors can ride the overall upward trend of the market without the complexities and uncertainties of active fund management.
• Accessibility and Liquidity: ETFs, in particular, are traded on stock exchanges like regular stocks throughout the trading day. This offers investors the flexibility to buy and sell at current market prices, providing greater liquidity compared to traditional mutual funds, which are priced only at the end of the day. While index funds are typically priced at the end of the day, their accessibility through various mutual fund platforms makes them convenient for systematic investment plans (SIPs).
• Government Initiatives and Investor Awareness: The Indian government has also played a role in popularizing ETFs, notably through divestments from public sector enterprises via the CPSE ETF route. The Employees’ Provident Fund Organisation (EPFO) investing a portion of its incremental flows into ETFs has further boosted its visibility and acceptance. Coupled with increasing financial literacy and the ease of online investing, investor awareness about the benefits of passive investing has grown significantly.

Challenges and Considerations

Despite their undeniable advantages, index funds and ETFs are not without their considerations:

• Market Risk: Like any equity-linked investment, index funds and ETFs are subject to market volatility. If the overall market declines, the value of these investments will also fall. They do not offer protection against bear markets.
• Lack of Flexibility: Passive funds are designed to strictly mirror their benchmark index. This means they cannot proactively adjust their holdings to defensive positions during extreme market conditions or avoid underperforming sectors or stocks within the index.
• Tracking Error: While the aim is to perfectly replicate an index, minor deviations known as “tracking errors” can occur due to factors like fund fees, rebalancing delays, or liquidity issues in underlying stocks.
• Concentration Risk (in some cases): Some broad market indices can become concentrated in a few top-performing stocks or sectors. While SEBI has introduced regulations to limit individual stock weights in broad market indices to 25%, a degree of concentration can still exist, exposing investors to potential risks if those concentrated holdings face headwinds.
• Trading Costs (for ETFs): While ETFs generally have lower expense ratios, they involve brokerage charges, Securities Transaction Tax (STT), GST, and stamp duty when bought or sold on exchanges, similar to stocks. These transaction costs can impact returns, especially for frequent traders.

The Future Outlook

The trajectory for index funds and ETFs in India remains strongly positive. The growing investor preference for low-cost, transparent, and diversified investment options is set to continue. The emergence of thematic and smart beta ETFs, which offer exposure to specific investment themes or factor-based strategies, will further broaden the appeal of passive investing. As India’s financial markets mature and investor sophistication increases, passive investment vehicles are poised to play an even more dominant role in the nation’s wealth management landscape. In conclusion, index funds and ETFs represent a fundamental shift in the Indian investment paradigm. Their simplicity, cost-efficiency, and diversification benefits are making them increasingly attractive to a wide spectrum of investors, from seasoned market participants to first-time entrants. While understanding their inherent risks is crucial, the current market scenario indicates that passive investing is no longer a niche concept but a mainstream and rapidly growing force in India’s financial future.