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The Index Game: Is Passive Investing Really Passive? Who Decides What's in Your 'Passive' Portfolio?

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Introduction: The Passive Investing Paradox

"Just invest in an index fund and relax," they said. "It's completely passive," they promised.

Over the last few years, passive investing has become the darling of Indian investors. From Nifty 50 index funds to Sensex ETFs, everyone seems to be jumping on the passive bandwagon. And why not? Lower costs, less hassle, no fund manager risk – sounds perfect, right?

If investing in an index is truly passive, then who decides which 50 companies go into the Nifty 50? Who decides that Reliance should have a bigger weight than Infosys? And when a company is kicked out of the index, who makes that call?

Suddenly, "passive" doesn't seem so passive anymore. But here’s the twist most people never think about:

If you’re not picking stocks… someone else is.
If you’re not deciding what goes into your portfolio… someone else definitely is.

1. Index Basics: What Are We Really Buying?

Let's start simple.

An index is basically a list of stocks put together to represent a part of the stock market. Think of it like a playlist of songs – except instead of songs, you have companies.

The Nifty 50 is a playlist of India's top 50 companies. The Sensex has 30 companies. The Nifty Midcap 150 has, well, 150 mid-sized companies.

But here's the thing – every playlist has a curator. Someone decides what goes in and what stays out.

Who Creates These Indices?

In India, we have:

  • NSE Indices Ltd – They manage the Nifty family (Nifty 50, Nifty Bank, Nifty Next 50, etc.)
  • BSE (Bombay Stock Exchange) – They run the Sensex and other BSE indices
  • CRISIL – They have their own set of indices

Globally, you'll hear about:

  • S&P Dow Jones Indices – The people behind the famous S&P 500
  • MSCI – Popular for international and emerging market indices
  • FTSE Russell – Another big player in global indices

These companies are in the business of creating and managing indices. Yes, it's a business. They earn money by licensing their indices to fund houses. When you invest in a Nifty 50 index fund, the fund house pays NSE Indices for using that "brand."

2. The Hidden 'Active' Decisions in Every Index

Now comes the interesting part – the decisions that make "passive" not so passive.

How Do Stocks Get Selected?

Let's take the Nifty 50 as an example. A company doesn't just walk into the Nifty 50. It has to meet certain criteria:

  • Size matters: The company must be large enough (high market capitalization)
  • Trading volume: The stock should be actively traded – nobody wants illiquid stocks
  • Free-float: At least 10% of shares should be available for public trading (not locked with promoters)
  • Listing history: The company should have been listed for at least 6 months

But here's the catch – these rules can change. NSE can modify them. And when they do, your "passive" portfolio automatically changes too.

Weighting: The Biggest Active Decision

Not all stocks in an index are equal. Some have bigger weights than others.

Market-cap weighting is the most common method. Simply put:

  • Bigger companies get bigger weights
  • Smaller companies get smaller weights

In the Nifty 50, as of recent times, the top 10 companies make up nearly 60% of the index. That means companies like Reliance, HDFC Bank, Infosys, and TCS dominate your portfolio.

Is that good or bad? Neither. It's just an active decision that the index methodology has made for you.

Other weighting methods exist too:

  • Equal weight: Every stock gets the same importance (imagine if all 50 Nifty stocks had 2% each)
  • Factor-based: Some indices give more weight to companies with specific characteristics – like high dividends, low volatility, or strong momentum

Each method will give you different returns. So choosing an index is already an active decision.

Rebalancing: When the Index Changes

Indices are not static. They change regularly.

Semi-annual review: Twice a year, NSE looks at the Nifty 50 and decides:

  • Should any company be removed?
  • Should any new company be added?
  • Should the weights be adjusted?

When a company is about to enter the Nifty 50, something interesting happens – its stock price often jumps. Why? Because all the Nifty 50 index funds now have to buy that stock. Increased demand = higher price.

This is called the "index effect" – and guess who pays for this price jump? You, the passive investor.

Similarly, when a company is kicked out, index funds have to sell it, often pushing the price down.

These are real costs that eat into your returns, even though you're investing "passively."

The Index Game: Is Passive Investing Really Passive?

3. Types of Indices: Choose Wisely

Not all indices are the same. And this is where you need to be really careful.

Broad Market Indices

These try to capture the entire market:

  • Nifty 500 (500 largest companies)
  • BSE 500

These are relatively safer bets if you want true market representation.

Popular Large-Cap Indices

  • Nifty 50
  • Sensex 30

These are concentrated in large companies. Good for stability, but remember – you're betting heavily on just 30-50 companies.

Sectoral and Thematic Indices

  • Nifty Bank
  • Nifty IT
  • Nifty Pharma
  • Nifty EV & New Age Automotive

These sound exciting, but be careful. They're essentially active bets on specific sectors. If that sector crashes, your entire investment suffers.

Smart Beta Indices

These try to be "smarter" than regular market-cap indices:

  • Nifty 100 Low Volatility
  • Nifty Dividend Opportunities 50
  • Nifty200 Momentum 30

They use factors like quality, momentum, or low volatility to select and weight stocks. Are they passive? Not really. They're rule-based active strategies disguised as passive investing.

4. Passive Investing's 'Active' Costs

"Index funds are cheap," they say. True, but not completely free.

Expense Ratio

Even the cheapest Nifty 50 index fund charges around 0.05% to 0.20% per year. It's low, yes, but it's still there.

Tracking Error

Your index fund is supposed to give you the same returns as the index. But it never does exactly. This difference is called tracking error.

Why does this happen?

  • The fund has to keep some cash for redemptions
  • There are transaction costs when rebalancing
  • Dividends are received at different times

A good index fund keeps tracking error minimal (below 0.5%), but it's worth checking.

Hidden Costs During Rebalancing

When the index changes, your fund has to:

  • Sell the stocks that got kicked out (often at lower prices)
  • Buy the new entrants (often at higher prices due to index effect)
  • Pay brokerage and taxes

These costs don't show up in the expense ratio, but they affect your returns.

Tax Implications

Starting from April 2023, equity index funds are taxed like any other equity fund.  When the fund rebalances internally, it might trigger capital gains, which can be a tax event for you.

5. Red Flags for Index Investors

Not every index deserves your money. Here are some warning signs:

🚩 Red Flag 1: Overly Narrow Indices

Indices with just 10-15 stocks are risky. You're putting all your eggs in very few baskets.

Example: Nifty Bank has only 12 banks. If the banking sector crashes, you're in trouble.

🚩 Red Flag 2: Trendy Thematic Indices

Remember when everyone was excited about New Age Automotive or EV indices? These chase trends.

The problem? By the time an index is created around a hot theme, the easy money has often already been made. You might be buying at the peak.

🚩 Red Flag 3: High Concentration in Top Stocks

Check how much weight the top 5 or top 10 stocks have. If it's more than 50-60%, you're taking concentration risk.

In Nifty 50, the top 10 stocks dominate. That's fine if you're okay with it, but know what you're signing up for.

🚩 Red Flag 4: Backtested Performance Looks Too Good

New indices often show amazing backtested returns. "This index would have given 20% returns over the last 10 years!"

But that's looking backward. The real question is: Will it work going forward?

Survivorship bias is real. The backtest includes only companies that survived and did well. It doesn't show the failures that got kicked out along the way.

🚩 Red Flag 5: Frequent Methodology Changes

If an index keeps changing its rules every year, that's a red flag. It shows that even the index provider doesn't have confidence in the methodology.

5. The Index Game: Why Companies Fight to Get Included

Being added to a major index is like winning the IPL auction for a player.

What happens when a company gets included?

  • Passive funds automatically buy it

  • Global ETFs start flowing money

  • Liquidity improves

  • Analysts begin covering it

  • More visibility → higher demand

It’s powerful.

Companies want to be in the index.

6. A Simple Checklist Before Investing in Any Index Fund

Before buying a passive fund, check:

  • ✔ What methodology does this index use?

  • ✔ How concentrated is it?

  • ✔ Which sectors dominate it?

  • ✔ How often is it rebalanced?

  • ✔ What is the tracking error?

  • ✔ Is the expense ratio reasonable?

This 2-minute check will save you from blindly following the word “passive.”

7. The Verdict: Passive in Execution, Active in Construction

So, is passive investing really passive?

Yes and No.

Yes, it's passive in execution:

  • You're not picking individual stocks
  • You're not timing the market
  • You're not relying on a fund manager's skill
  • You're simply buying the entire basket and holding

But no, it's not passive in construction:

  • Someone decided which stocks to include
  • Someone decided how to weight them
  • Someone decides when to rebalance
  • All these are active decisions

Think of it this way: You're not driving the car, but someone else chose the route for you. You're still going somewhere specific, not just "anywhere."

When Does Passive Work Best?

Passive investing works beautifully when:

  • You want broad market exposure (like Nifty 500 or Total Market indices)
  • You're investing for the long term (10+ years)
  • You want to keep costs low
  • You believe that markets are reasonably efficient

When Should You Question Your Index?

Be cautious when:

  • The index is too narrow or thematic
  • It has very high concentration in a few stocks
  • It's a new, untested index with great backtested returns
  • The methodology seems complex or keeps changing

8. Practical Wisdom for the Index Investor

Here's how you can be a smarter passive investor:

1. Do Your Vichara (Contemplation)

Don't just invest because "everyone is doing index funds." Ask yourself:

  • What am I trying to achieve?
  • Which part of the market do I want exposure to?
  • Am I comfortable with the concentration in this index?

2. Read the Index Methodology Document

Yes, it's boring. Yes, it's technical. But spend 30 minutes reading it.

You'll find it on the NSE Indices or BSE website. It tells you exactly how the index works.

3. Check the Tracking Error

A good index fund should have minimal tracking error. Check the fund's monthly factsheet. If the tracking error is consistently above 1%, something's wrong.

4. Look at the Top Holdings

Before investing, check what the top 10 stocks are and how much weight they have. Make sure you're comfortable with that concentration.

5. Review, But Don't Obsess

You don't need to check your index fund every day. But once a year, review:

  • Is the tracking error acceptable?
  • Has the index methodology changed?
  • Does this still align with my goals?

Conclusion: Informed Passivity is the Best Strategy

Let me tell you a small story.

A few years ago, my friend Ramesh proudly told me he's now a "passive investor." He had invested ₹5 lakhs in a Nifty Bank Index Fund.

When I asked why he chose Nifty Bank, he said, "Because everyone says passive is the best. And banks are important, no?"

Two years later, when the banking sector went through a rough phase, his investment was down 15%. He was frustrated. "You said passive investing is safe!"

I never said that. What I said was: Passive investing is simple, not simplistic.

The truth is, every investment decision – active or passive – requires thought.

When you invest in an index:

  • You're trusting someone else's methodology
  • You're accepting their active decisions about selection, weighting, and rebalancing
  • You're betting on a specific slice of the market

And that's perfectly fine – as long as you know what you're doing.

Passive investing is powerful. It has helped millions of investors build wealth without the stress of stock picking. But it's not a substitute for thinking.

So before you put your hard-earned money into an index fund, do your vichara:

  • Understand what the index represents
  • Read how it's constructed
  • Know what you're benchmarking against
  • Be aware of the hidden active decisions

Remember, in investing, even "doing nothing" is doing something. Make sure that something aligns with your financial goals.

Resources for Further Learning

Want to dig deeper? Here are some useful resources:

Index Methodologies:

Learn More:

  • SEBI Investor Education materials
  • Read factsheets of index funds before investing

Happy investing! And remember – stay curious, stay informed, and always do your vichara.

- Money Vichara

What are your thoughts on passive investing? Have you ever wondered who decides what goes into your index? Share your vichara in the comments below!

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