Lokeshwarri SK

Is this the dawn of the passive investing era?

Lokeshwarri SK | Updated on January 01, 2020

Slow-going India is quite late in joining the passive investing movement   -  Artystarty

Assets of passive funds in India surged in 2019. But awareness is still low, impeding progress

There was a time when passive investing was summarily dismissed by Indian investors. With the Indian equity market in a strong uptrend until 2017, most fund managers managed to beat the benchmarks effortlessly, presenting a strong case for active fund management.

But the tide seems to be gradually turning. There was a strong inflow into equity exchange traded funds (ETFs) in 2019. Assets under management of ETFs, other than gold, had been ₹70,041 crore towards the end of November 2017; this rose to ₹94,863 crore in November 2018 and then to ₹1,63,923 crore by the end of November 2019.

It is commonly believed that the surge in these assets is due to the EPFO, which has to regularly invest into the equity market through the ETF route. But only 15 per cent of the incremental corpus of the EPFO is invested in to equity market every year. That translates in to approximately ₹18,000 crore. It’s therefore apparent that other investors are also beginning to embrace passive investing in India.

India is actually quite late in joining the passive investing movement. Morningstar had reported that assets under management of passive funds, including ETFsand mutual funds, in the US had surpassed the assets of actively managed funds in the second half of 2019. Investors in the US have, in fact, been consistently withdrawing funds out of actively managed funds to invest into passively managed funds.

Struggles in active funding

The proponents of passive investing in Indian have become louder of late due to the struggle that equity funds are facing in beating their respective benchmark returns. Of the 31 large-cap funds, 16 have failed to beat their benchmark returns in 2019. Of the 43 ELSS funds, 28 delivered returns that are lower than their benchmarks. Underperformance in many sectoral funds was also stark.

That said, it is also obvious that Indian fund managers are able to generate alpha, when given sufficient room to perform. Under-performance among mid-cap funds was just 4 per cent, while only 19 per cent of the small-cap funds did worse than their benchmarks last year. These numbers are in line with our research published on March 10, 2018 (Why passive funds are better).

We had concluded in that piece that passive investing would work better in the large-cap segment while managers can outperform the benchmark in small- and mid-cap segments.

Underperformance in the large-cap funds is due to various reasons including excessive demand for larger stocks that are perceived as less risky, making their valuations pricey, limiting options in this segment. The assets managed by these funds have swelled in recent times, making it more difficult for fund managers to make deft changes in the portfolios. Also, the restrictions on sectoral exposure prevents large-cap funds from following the indices and loading up stocks from sectors with superior near-term prospects.

This trend of equity fund under-performance is not restricted to India. The S&P Dow Jones indices’ SPIVA report shows that 78.5 per cent of large-cap funds in the US have underperformed the indices over a five-year period while the under-performance was around 70 per cent over one- and three-year periods. In Europe, 90 per cent of equity funds underperformed the benchmark over a one-year time frame while 77 per cent underperformed over 5 year period. In emerging markets such as Brazil and South Africa too, most equity funds have been lagging their benchmark returns over all time frames.

Why passive makes sense

This under-performance of actively managed funds across the globe has been strengthening the case for shifting towards passive funds.

Passive investing appears to be a win-win for all stakeholders. Given the poor performance of active large-cap funds, index-based investing could give superior returns to investors. Also, they do not have to worry about tracking the funds’ portfolio or fund manager’s performance while selecting a passive fund. They can create a portfolio of passive funds, with various themes and strategies, to generate higher returns. Fund houses can bring down the expenses incurred in research and fund managers’ salaries if the shift towards passive investing gains ground. Regulators can also rest easy with passive funds since it is not possible to use funny tricks to perform better, in such funds.

The biggest factor favouring index funds and ETFs is the lower expense ratios that help increase returns, due to the compounding benefit. This tends to play a larger role in periods when equity returns are muted.

While the compounded average annual growth in the Sensex was 21 per cent between 1980 and 1999, in the next two decades, the growth slowed down to around 12 per cent. The annual growth since 2010 has been even slower, at 7.5 per cent. It is therefore not surprising that investors may want to pay lower fund management fee commensurate with the returns, and hence can turn to ETFs and index mutual funds.

Regulatory push

But while there is a strong case for turning towards passive funds, the movement is yet to gain traction in India. ETFs and index funds account for just 6.5 per cent of total mutual fund assets in India. One factor that is impeding the growth of passive investing in India is the lack of interest from mutual fund distributors, due to the lower commission on these funds.

With 85 per cent of retail investors in equity mutual funds relying on advisers to invest, SEBI could consider allowing mutual funds to pay slightly higher commissions for pushing index funds and equity ETFs to retail investors. This can help increase awareness about these products.

Index funds are preferred over ETFs by MF investors since index funds can be purchased even if the investor does not own a demat account. Also, it is possible to undertake SIPs (systematic investment plans) in these. But despite the obvious benefits, corpus of index funds in November 2019 was only ₹7,717 crore. While this is up from ₹4,385 crore in November 2018, it is still woefully inadequate.

Both the NSE and the BSE have created a full array of equity indices (sectoral, thematic, strategy, broad market) and fixed income indices (government securities, corporate bond, money market, SDL indices and aggregate). Some fund houses are beginning to test the water with ETFs based on smart beta or dividend strategies. But more such funds need to be launched and that can happen only when awareness increases.

The market regulator can specify that some investor education programs need to be targeted at educating investors about the passive investing option, so that they can make an informed decision.

With inputs from

Dhuraivel Gunasekaran

Published on January 01, 2020

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