Potential for passive investing in Indian financial markets

The age-old debate of active versus passive investing continues to rage 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 (ETFs). In both cases, the product aims to reproduce the makeup index and mimicking stock weights. An index fund is typically offered by distributors and fund companies, while an ETF is listed on a stock exchange.

India has always been an active investment market, dominated by mutual fund managers deploying active strategies. However, the numbers show that passive investing is catching up quickly, mainly thanks to returns. For example, let’s analyze the large cap equity category. In the 12 months ending December 2020, the S&P BSE 100 rose 16.84%, with 80.65% of large-cap Indian equity funds underperforming the benchmark.

Yields in turn stimulate entry and demand. Total assets under management of index funds increased from Rs 8,082 crore to Rs 13,017 crore in calendar year 2020 (until October 2020), an increase of 61%. ETFs saw an increase from Rs. 1,84,534 crore to Rs. 2,27,332 crore, an increase of 29%, including gold ETFs.

There are several reasons for the growth of passive investment in India.

Passive investing has shown better returns

Investors are driven by the data, and the data clearly shows that active fund managers have struggled to keep up with broad stock indexes. This is by far the main reason for the rise in passive investing.

Increase in 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. Meanwhile, AUM has grown from 200 crore to 1.75 lakh crore, an annual growth rate of 97%.

Reduced fees associated with passive investing

A big reason for organic growth in liabilities has to do with the costs associated with the two groups. In India, average fees for equity funds are around 200 basis points, while ETFs enjoy fees of only 5 basis points on average. This is because, while an active manager seeks to continually refine a portfolio, resulting in constant buying and selling of securities, a passive fund manager is simply looking to track an index. It becomes a buy and hold strategy, resulting in hyper-efficiency and less “drag”. The role of the fund manager is to make minor adjustments from time to time to capture the appropriate asset weights. From an overhead perspective, since there is no stock selection team, the costs are significantly lower. From a tax perspective, passive funds are also advantageous because less capital gains are captured due to less sale of assets.

Passive investing complies with regulations

Sebi has taken a hands-on approach to promote passive investing in India. For example, at the end of 2017, it changed its rules on the ownership of large and mid-capitalization companies. Large-cap equity funds were now required to invest at least 80% of their holdings in large-cap stocks, and mid-cap equity funds were required to invest at least 65% in mid-caps. This limited the ability of active fund managers to be flexible in their decisions, resulting in higher fees and lower performance going forward.

Likewise, in 2018, it modified the calibration rules for active equity funds in order to more accurately represent the performance of active funds.

Another intervention by Sebi came in May this year when she asked asset management companies to pay at least 20 percent of gross salaries to key employees as 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 companies to retain talent as they have to set aside a larger budget for future salaries.

The road ahead

As proof, the trend towards passive investment is strong and seems likely to continue, although passive investment still lags behind active investment in India. The total assets under management of index funds and ETFs represent less than 10 percent of the overall assets under management of the mutual fund. In countries like the United States, the ratio is closer to 50/50. Over the next decade, the ratio in India can be expected to mimic that of the United States.

We can also expect a steady increase in inflows into index funds and ETFs and general consolidation of actively investing AMCs. Increased investor awareness and a favorable regulatory environment have paved the way for the possibility of continued long-term growth in low cost passive funds in India.

The author of this article is co-founder of RAIN Technologies

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