Potential of Passive Investing in Indian Financial Markets

The age-old debate of active vs passive investing continues to rage on in 2021, and the passive crowd seems to be gaining momentum. First, a quick overview of the differences. Passive investing mimics the returns of an index, while active investing tries to outperform an index. The two most popular passive investing options in India involve index funds and exchange-traded funds (ETF’s). In both cases, the product is aiming to replicate the make-up of the index and mimicking the stock weights. An index fund is usually offered by distributors and fund houses, while an ETF is listed on a stock exchange.

India has historically been an active investing market, dominated by mutual fund managers deploying active strategies. However, the numbers show that passive investing is catching up quickly, mostly driven by returns. For example,  let’s analyse the equity large-cap category. In the 12 months ending Dec 2020, the S&P BSE 100 was up 16.84 per cent, with 80.65 per cent of Indian equity large-cap funds underperforming the benchmark.

The returns are in turn driving inflows and demand. The total AUM of index funds grew from Rs 8,082 crore to Rs 13,017 crore in the calendar year 2020  (through Oct 2020), an increase of 61 per cent. ETFs saw an increase from Rs. 1,84,534 crore to Rs. 2,27,332 crore, an increase of 29 per cent, when we also account for gold ETFs.

There are multiple reasons for the growth of passive investing in India.

Passive investing has shown better returns

Investors are driven by data, and the data clearly shows that active fund managers have struggled to keep up with the general stock market indices. This is by far the largest reason for the surge in passive investing.

Growth of availability

Another reason is due to the availability of more products. Over the past 10 years, the number of ETFs offered has grown from 57 products to 99 now. During that time, the AUM has grown from 200 crore to 1.75 lakh crore, an annual growth rate of 97 per cent.

Lower fees associated with passive investing

A large reason for the organic growth in passive has to do with the fees associated with both groups. In India, the average equity fund fees comes out to around 200 bps, while ETFs enjoy fees of just 5 bps on average. This is due to the fact that while an active manager is looking to continuously tweak a portfolio resulting in constant buying and selling of securities, a passive fund manager is merely looking to replicate an index. This becomes a buy and holds strategy, resulting in hyper-efficiency and less “drag”. The fund manager’s role is to make minor adjustments every so often to capture proper weightings of assets. From an overhead perspective, as there is no stock-picking team, costs are significantly lower. From a taxation perspective, passive funds are also beneficial as fewer capital gains are captured due to less selling of assets.

Passive investing is regulatory friendly

Sebi has taken a hands-on approach to promoting passive investing in India. For example, in late 2017, it changed its rules on holdings of large-cap and mid-cap firms. Large-cap equity funds had to now invest at least 80 per cent of their holdings in large-cap stocks, and mid-cap equity funds had to invest at least 65 per cent in mid-caps. This restricted active fund managers’ abilities to be flexible with their decisions, resulting in higher fees and lower performance moving forward.

Similarly, in 2018, it changed benchmarking rules for active equity funds to more accurately depict active fund performance.

Another intervention by Sebi occurred in May of this year when it asked asset management companies to pay at least 20 per cent of gross salaries to key employees in the form of units in the scheme managed by the AMC. The rule only applies to active fund houses, not index funds or ETFs. Essentially, this makes it a bit more difficult for active fund houses to retain talent as they need to set aside a higher budget for future salaries.

The road ahead

As evidence, the trend towards passive investing is strong and seems likely to stay, although passive investing still lags active investing in India. The total AUM of index funds and ETFs make up less than 10 per cent of the overall mutual fund AUM. In countries like the US, the ratio is closer to 50/50. In the coming decade, we can expect the ratio in India to mimic that of the US.

We can also expect a steady increase of inflows into index funds and ETFs and a general consolidation of active investing AMC’s. An increase in investor awareness and a regulatory-friendly environment has set the stage for the possibility of continued long-term growth into low-cost passive funds in India.

The author of this article is Co-Founders of RAIN Technologies 

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