Building a Passive Core: Broad vs Narrow Indices, Overlap, Smart Beta and Active Funds

What you will learn: how to design the passive part of an equity portfolio so that each fund does a distinct job: telling broad indices from narrow ones, measuring overlap between indices, judging factor and "smart beta" indices on their rules, and recognising where an actively managed fund may still earn a place.

Ananya Ghosh (an illustrative profile), 38, an architect in Kolkata, has ₹10 lakh of long-term equity money spread across four passive funds collected over the years: ₹4 lakh in a fund tracking a top-50 large-company index, ₹3 lakh in an ETF on the top-100 index from the same provider, ₹2 lakh in a fund on the "next 50" index and ₹1 lakh in a momentum index fund a colleague recommended. Four funds sounds diversified. Her question: "Do these four funds actually own different things, and what should a simple passive core look like?"

How much of a household's money belongs in equity at all is a separate decision, covered in risk, diversification and asset allocation. This lesson starts after that decision: given an equity amount, how do you hold it passively without accidental duplication or hidden bets?

What a passive core is for

A core is the part of the portfolio meant to capture the market's return at low cost, with few decisions to second-guess. It should be broad, cheap to hold, simple to review and boring to own. Anything added around it, whether a sector fund, a factor fund or an active fund, is a deliberate satellite bet with a reason you can write down.

Three tests help decide whether an index can serve as a core:

• Breadth: how much of the investable market it covers. NSE Indices' methodology document states that the Nifty 50 represents about 66% of the free-float market capitalisation of stocks on NSE. Broader indices such as the Nifty 500 or a total-market index reach further into mid and small companies.
• Rule simplicity: free-float weighting with semi-annual reviews needs little trading. Rules that reshuffle holdings often generate more cost and more surprises.
• Concentration: the weight of the top ten stocks and the largest sector. A broad index can still lean heavily on a few banks or technology companies; that is the market's own concentration, accepted knowingly.

Broad, size-based, sector and factor indices compared

Size-segment indices are often nested. The Nifty 100 contains the Nifty 50 and the Nifty Next 50; the Nifty 500 contains all of them. That nesting is exactly what caused Ananya's duplication. The rules behind these indices are explained in how an index is built.

Measuring overlap between indices

The choosing and reviewing funds lesson shows the basic overlap measure: add up the smaller of the two weights in each common holding. For index funds this becomes easy, because the index rules tell you the answer before you look at any factsheet.

Worked example: overlap of nested and differently weighted indices

Assumptions (illustrative): in a top-100 index, the 50 largest companies make up 85% of the weight and the next 50 make up 15%. Both the top-50 and top-100 indices are free-float weighted without binding caps.

• Top-50 index and top-100 index: every top-50 company appears in both, and in the top-100 index each carries its weight × 0.85. The smaller weight in each pair is always the top-100 weight, so overlap = 85%.
• Top-50 index and next-50 index: no common companies, so overlap = 0%.
• Cap-weighted and equal-weighted versions of the same ten stocks: assume cap weights of 20, 16, 14, 12, 10, 8, 7, 6, 4 and 3% against 10% each. Summing the smaller weight in each pair gives 78%. Same companies, but 22% of the money sits differently.
• A momentum index against that ten-stock cap-weighted index: assume the momentum index holds four of the ten (weights 6, 18, 22 and 20% against cap weights of 20, 12, 8 and 6%) plus three other stocks. Overlap = 6 + 12 + 8 + 6 = 32%, even though 66% of the momentum index's money is in companies the cap-weighted index also owns.

Overlap by name and overlap by weight answer different questions. Weight is what drives returns.

Worked example: Ananya's look-through

Assumptions (illustrative): the top-100 ETF holds 85% in top-50 companies and 15% in next-50 companies; the momentum fund currently holds 55% in top-50 companies, 30% in next-50 companies and 15% in companies outside the top 100.

Four funds behave very much like one top-100 portfolio with an extra tilt towards the next-50 companies, plus a small momentum bet. Only 1.5% reaches beyond the 100 largest companies. That may be fine, but it is not what "four funds" suggested. If Ananya wants exposure to mid and small companies, a broader index would deliver it directly; if she does not, two of her funds add paperwork without adding diversification.

Factor and smart-beta indices: passive rules, active choices

Factor indices follow published rules, so a fund tracking them is passive in execution. But someone chose the rule, and owning it is an active bet that a characteristic will be rewarded. Published methodologies show how different these rules are: the Nifty50 Equal Weight resets every stock to 1/N each quarter; the Nifty200 Momentum 30 picks 30 stocks by six- and twelve-month price momentum adjusted for volatility, reviewed in June and December, with each stock capped at the lower of 5% or five times its free-float weight.

Worked example: the trading an equal-weight rule creates

Assumptions (illustrative): a five-stock equal-weight index starts at 20% each. Over a quarter the stocks return +18%, +6%, −4%, +2% and −12%. The weights drift to 23.14%, 20.78%, 18.82%, 20.00% and 17.25%. Resetting to 20% each means selling winners and buying losers worth 3.92% of the portfolio (one-way turnover) every quarter, about four times a year. A cap-weighted index would need no trade at all, because its weights move with prices. That turnover costs money inside the fund and shows up in tracking difference and expense ratio.

Before adding a factor fund, check four things:

• The rule: what is bought, how often it changes, and what caps apply.
• The history: many factor indices have base dates long before they were launched, so part of the record is back-calculated. Find the launch date in the index factsheet and treat earlier data as a test, not a track record.
• The cost: expense ratio and tracking difference are usually higher than for a broad cap-weighted fund.
• The patience required: factors go through long spells of lagging the broad market. A factor fund you will sell after two bad years is a cost, not a strategy.

When an active fund may still fit

A passive core does not make active management wrong by definition. It raises the bar. As an illustration, ₹10 lakh growing for 15 years at an assumed 11% a year becomes ₹45,94,247 with a 0.30% annual tracking difference, but ₹41,77,248 with 1.0% annual costs at the same gross return, a gap of ₹4,16,999. An active fund costing 1.0% a year has to earn about 0.7 percentage point a year more than the index, before its costs, just to match the passive fund after costs. Situations where investors may reasonably consider active management include:

• segments where index construction is harder or trading costs are high, such as smaller companies, where an index fund's own tracking can be weaker;
• debt and hybrid needs, where the job (managing credit, duration or asset mix) may not be captured by a suitable index;
• a specific constraint the index cannot meet, such as excluding certain sectors; and
• a fund with a long, consistent record, judged against the right total return index after costs, with a process you understand.

Whichever route you take, judge it by the same rules: purpose, benchmark, costs and a review date. None of this suggests a particular fund or mix for you.

Try this: a two-hour passive core review

1. List every equity fund the household owns, including employer and NPS equity, with the index or benchmark each follows.
2. Group them by index family: broad, size segment, sector or theme, factor, active.
3. For nested indices, estimate the look-through split as in Ananya's table using the latest index factsheets.
4. Calculate overlap by weight for any two funds that look similar, and remove a fund only after checking exit load and tax.
5. Write one line for each satellite: what it is for, how long you will hold it, and what result would make you exit.
6. Set a review date and a rebalancing band, using the rebalancing method if you also hold global funds.

Common questions

Where to go next

• Tracking difference and total cost to compare funds on the same index.
• Risk, diversification and asset allocation for setting the equity share first.
• Direct stocks vs mutual funds if you also hold shares directly.
• Further reading: a portfolio-first framework for choosing funds.