The Rise Of Passive Funds: Should You Ride The Wave?

Over the last 5-10 years, passive funds have surged in size and popularity in India as well as in the international markets like the US. In the US, the assets in passive funds has grown four times in the past decade from $3.2 trillion at the end of 2013 to $15 trillion at the end of 2023. Says Anil Ghelani, CFA, head – passive income and products, DSP Mutual Fund: “With passive funds witnessing positive flows consistently over the past decade, for the first time in history of the US mutual fund industry, the assets under management (AUM) of passive funds has crossed that of active funds.”

In India, the share of passive funds’ AUM has doubled from 8 per cent of the mutual fund industry AUM in August 2020 to 16 per cent in August 2024. In just one year, as of August 2024, the AUM of passive funds has increased from Rs 7.58 trillion to Rs 10.96 trillion, a growth of 45 per cent. In the last three years, passive funds got a higher net inflow compared to active funds in the large-cap category. According to experts, this trend is likely to continue.

“While in some global markets like the US, we have already seen passive funds taking over in size; in India we are seeing a gradual growth. In my view, together with growth in the overall industry, we will see this (passive funds’) proportion increase to 25 per cent in the next 3-5 years,” says Ghelani.

This evolving scenario gives rise to the question: are passive funds outperforming active management, or are they creating a more competitive and cost-effective option that ultimately benefits the investors?

The Turning Point

Historically, passive funds were closely linked to index investing, primarily focused on replicating the performance of broad equity indices, such as the Nifty and the Sensex.

Index funds and exchange-traded funds (ETFs) are passively managed funds that mimic their underlying benchmark in terms of portfolio, providing returns similar to that of the benchmark they track.

In contrast, active funds are managed by fund managers who actively make investment decisions in an attempt to outperform the benchmark index.

After 2013, innovation began in the passive fund space. Fund houses started launching market capitalisation-based passive funds and equal-weight index funds. This evolution continued as they refined their strategies by introducing more sophisticated products, such as smart beta index funds.

Smart beta index funds consider multiple financial metrics such as price-to-earnings (P-E), book value, dividend yield and so on. They are not limited to domestic investments across sectors and use various strategies. They even allow you to invest in major foreign indices from across the world.

The concept of passive funds—both index funds and ETFs—is not new in India, but they first caught the fancy of investors in 2014 when the government introduced ETFs as a method of disinvestment of central public sector enterprises (CPSEs) by launching CPSE ETF comprising of 10 CPSEs. Another ETF, Bharat-22 ETF, was launched in 2017 comprising 16 CPSEs, three public sector banks and three private sector companies. Through various offers of CPSE ETF and Bharat-22 ETF, the government has been able to realise disinvestment proceeds of Rs 98,949 crore since 2016-17.

Says Chintan Haria, principal investment strategist, ICICI Prudential Mutual Fund: “The government approach of doing disinvestments through ETFs brought people there. The financialisation that we are seeing in India has led to ETFs becoming much bigger. The size of the ETF market in India is more than Rs 7 lakh crore and it is growing at a significant pace.”

The Rise

Various factors have contributed to the rise of passive funds, starting from institutional thrust to financialisation of investments where investors have shifted from traditional products to higher-yielding financial products.

Additionally, the introduction of the Securities and Exchange Board of India-Registered Investment Advisor (Sebi-RIA) model in 2013 spurred the demand for low-cost investment products, making passive funds a fitting choice.

Siddharth Srivastava, head - ETF product and fund manager, Mirae Asset Investment Managers (India), attributes the rise of passive funds to the underperformance and lack of consistency of active mutual funds, along with their relative low cost and simplicity.

“Investor awareness, availability of data pertaining to fund performance and options, growth of mutual fund folios and (rise in) demat accounts has further helped the growth in passive AUM,” says Srivastava.

EPFO Thrust: The passive fund space got a major boost in 2015, when the government allowed the Employees’ Provident Fund Organisation (EPFO) to invest its corpus in index funds and equity-related investments. This allocation started at 5 per cent in August 2015, was later increased to 10 per cent, and reached 15 per cent in September 2017.

The influx of EPFO money in passive funds has experienced a remarkable jump, soaring from Rs 14,983 crore in 2016 to Rs 53,081 crore in 2023. According to industry experts, EPFO is now the largest institutional investor in ETFs, and primarily invests in those that track the two major indices, the Nifty and the Sensex.

The EPF is considered the largest retirement savings scheme in India, providing statutory benefits to employees after retirement or upon leaving service.

Demat Culture: Another reason is the increase in the number of demat accounts. Post Covid-19, the number of demat accounts increased multifold and more people got to know about ETFs.

According to depositories, Central Depository Services (India) Limited (CDSL) and National Securities Depository Limited (NSDL), the total number of demat accounts have reached 171 million as on August 31, 2024, almost six times the number in August 2020.

On the back of this growing number, fund houses have launched a flurry of ETFs in the last few years. It may be noted that one needs a demat account to invest in ETFs. According to Nifty insights in June 2024, there were only 87 ETFs offered by various fund houses till March 2020, which grew to 212 by June 2024 (see Historical Trend: ETFs).

Says the CEO of a top fund house, on the condition of anonymity, “When a new stock market trader burns their finger in stock trading, they often come back to ETFs considering they will be less risky than a single-stock investment. So, we need to offer them multiple options to choose from.” Some of the newly launched fund houses, such as Groww, Zerodha, Shriram Mutual Fund offer only ETFs to investors.

New Avenues For Fund Houses: The word from the industry is that another reason for fund houses to launch passive products is the restriction to come up with new schemes in the active fund categories.

Capital market regulator, Securities and Exchange Board of India (Sebi) came up with a circular “Categorization and Rationalisation of scheme” in 2017, which states that fund houses cannot have more than one scheme from each category. In the passive and thematic space, however, funds can launch schemes tracking different benchmarks.

Experts, however, do not necessarily agree with this logic, and believe that there’s always scope to offer innovative products even in the active categories.

Says Ghelani: “I strongly believe this is not a reason. The regulatory guidelines for scheme categorisation are very prudent and do not stifle product innovation for either passive or active funds. Even for active funds under the category of thematic funds, multiple funds are permitted as long as the theme or sector or strategy is different. So, we always have opportunities to design and execute new ideas across both styles of management.”

This is evident from the newly launched factor or thematic funds which track a sector or theme.

Underperformance of Actively Managed Funds: The debate between active and passive funds often takes centre stage on which strategy yields better performance.

Active fund managers are supposed to outperform underlying benchmarks through research and stock selection, while passive funds aim to replicate the index performance at a lower cost.

Some critics, who argue in favour of index funds, say that many active funds fail to consistently beat their benchmarks, especially after accounting for fees.

According to a study done in 2023 by S&P Dow Jones Indices, the world’s leading index provider, the performance among active fund managers varied across categories that year.

Over half of Indian equity large-cap funds failed to beat their benchmark, with 52 per cent of actively managed funds underperforming the S&P BSE 100. Additionally, 30 per cent of tax-saving funds underperformed against their benchmark, the S&P BSE 200.

The report further noted that the benchmark for Indian equity mid- and small-cap funds, the BSE 400 MidSmallCap Index, rose by 44 per cent in 2023, with 74 per cent of active managers underperforming this index during that period. This category of funds also fared the worst over the long term, with 75 per cent lagging behind the BSE 400 MidSmallCap Index over the 10-year period ending December 2023.

“Often, the underperformance of active fund managers is cited as a reason why investors are attracted to passive funds. While that might be true to some extent, I believe the other key driver is simplicity,” says Ghelani.

However, the majority of active fund managers argue that the returns of active funds should not be compared with that of the benchmark index, but instead with the index fund pegged to the benchmark index. Otherwise, the comparison could be misleading. Their rationale is that index funds incur fund management charges like active funds (though the charges are lower in index funds), which can lower the overall returns.

In order to check this thesis, we analysed the latest performance data as on September 30, 2024, for large-cap active funds.

We examined the one- three-, and five-year performance metrics of direct plans of active funds in the large-cap category (as this category faced the maximum heat for underperformance), and compared the returns with both the respective benchmark index (Nifty 100 Total Return Index (TRI) in this case)—which accounts for dividend income and provides a more accurate data of index performance over time—and the index fund pegged to broader benchmark indices Nifty and Sensex.

Our analysis revealed some interesting facts on the underperformance thesis. Among the 27 schemes in the large-cap category with a five-year track record, the category average return was 20.14 per cent over the last five years, compared to 19.80 per cent for the Nifty 100 TRI.

This clearly shows that on category average basis, large-cap active funds have outperformed their respective benchmark index. To be precise, 17 out of the 27 schemes surpassed their own index over this five-year period.

When compared to the average return of index funds, which stood at 18.30 per cent, 22 of the 27 active schemes managed to outperform their benchmarks. Over one- and three-year periods, out of the total 29 schemes, the number of underperformers decreased to one and three schemes, respectively (see How They Compare).

This implies that if you had randomly selected any of the three large-cap schemes, there is a strong probability that about two out of three would have outperformed index funds in the long run.

However, even this analysis does not give the exact picture, as most of the index funds that have been in existence in the last five years are either tracking the broader indices, such as the Nifty 50 TRI or BSE 30 TRI. In contrast, actively-managed large-cap funds are benchmarked against the Nifty 100 TRI or BSE 100 TRI indices.

The scope of underperformance diminishes in passive funds as they aim to replicate the performance of a specific benchmark index. This helps them deliver returns closely aligned with that of their benchmarks.

Changing Advisory Landscape: This is another major factor why fund houses have flocked to passive funds.

The introduction of the RIA regulation in 2013 and direct plans in the same year changed the mutual fund distribution landscape. Prior to this, distributors focused on schemes offering higher commissions. Now, Sebi RIAs recommend passively managed index funds or ETFs along with direct plans of actively managed funds. Sebi RIAs charge an upfront advisory fee from investors rather than earning commission from the fund house on their sales.

What It Means For You?

Unlike in the past, passive mutual fund investors have a wider range of options to choose beyond just the broadly-tracked indices. The introduction of more sophisticated products, such as smart beta funds has added to the list of options for investors across varying levels of risk appetite, thereby bringing in diversification, too.

In the past two years, there has been significant traction in smart beta funds where investors are getting attracted due to its uniqueness to target specific strategies, such as alpha, momentum, quality, low volatility, equal weight and thematic options.

For instance, when investing in an index fund or ETF that tracks the Nifty, fund managers had to strictly adhere to its composition. However, factor investing has created new opportunities.

One such example is the equal-weight index fund, where the fund invests in the same stocks as the index, but assigns equal weight to all constituents. For instance, in the Nifty index, there are 50 stocks, but their weights vary; HDFC Bank has highest weight of 11.34 per cent, while TCS has only 3.76 per cent by weightage as on October 16, 2024, and so on. The equal-weight index fund, will, however, give the same weightage to all the stocks rather than mimic the index in the exact proportion. This approach allows for a more balanced exposure across all the stocks in the index.

“Such products are allowing investors to target a certain return and risk profile and these funds have behaved in a manner that they are supposed to, which has added to their popularity,” says Srivastava.

These products allow investors to access opportunities which may not be available on the active side and sit well in their portfolio from a tactical or a strategic point of view.

Srivastava adds: “The availability of such equity products in the passive segment has certainly helped its cause as the conversation has moved away from “active versus passive” to “potential, utility and opportunities” of certain passive offerings.”

Cost-effectiveness is another significant advantage.

Passive funds have lower expense ratios compared to actively-managed funds, allowing investors to retain a larger portion of the returns. Moreover, the increased availability of passive options translates into greater accessibility.

What Should You Do?

With fund houses launching ETFs one after another, there are a lot of similar funds in the market.

Says Srivastava: “Investors should understand the method and intent of a passive fund and only invest if it caters to their risk and return profile. They should avoid investing in multiple funds from the same market-cap segment, strategy or theme. While picking a new option, they should evaluate its value addition in the overall portfolio.”

Also, different passive funds cater to different needs.

Says Haria: “If you are an investor looking for broad-based market participation, then you can consider investing in products based on indices, such as Nifty 50 or Nifty 100. If the need is towards a broader market, then there are schemes tracking mid- and small-cap indices, which can help achieve this requirement. There are also thematic and/or sectoral offerings which a savvy investor can consider.”

But does that mean you should not consider active funds at all?

At times active funds may turn you down, but they have the potential to deliver market-beating returns.

Says Haria: “When it comes to portfolio construction, the ideal approach is to have a blend of active and passive funds.”

However, it should also be noted that it’s much simpler to select an index fund compared to an actively-managed equity fund.

kundan@outlookindia.com