The idea of passive funds came into existence almost 50 years ago in the United States. As the information asymmetry reduced, and markets became more efficient, the probability of active funds outperforming the underlying benchmark decreased. This prompted investors to turn to passive funds in developed markets. In India, we have witnessed a surge of flows towards passive funds over the past couple of years.
What are passive funds? Passive funds are funds in which a fund manager does not deploy any strategy and invests all the assets in stocks of a particular index. Index Funds, that track the underlying benchmark index and Exchange Traded Funds (ETFs), which are traded on the exchange like a normal stock (unlike a mutual fund scheme which can be only bought from an AMC) are collectively termed as passive funds.
The money managed by passive funds in India currently stands at Rs 80,800 crore which contributes to 3.9% of the active funds in the industry as on 31st Mar-18. Since 2016, AUM in passive funds has grown at the rate of 82% YOY. This was driven by the Government’s decision to disinvest its stakes in PSU entities through the ETF route.
Securities and Exchange Board of India (SEBI) is pushing for growth of these funds to drive costs down for investors and increase transparency. Recently, the government issued a notice inviting AMCs to submit a proposal for the launch of Debt ETF by 17th December’18 with SEBI. The government will select and appoint one AMC having expertise and experience in launching debt mutual funds/ETFs/debt assets.
Although passive investing is experiencing notable momentum owing to strong domestic influences like investment in these funds by the Employees’ Provident Fund Organisation (EPFO), it is difficult to assess by when passive fund management would outpace active management.
Passive funds an ideal choice if confused about fund manager selection
We reached out to experts to know their views on passive funds investing. Nilesh Shah, MD & CEO, Envision Capital, says, “I come from a school of thought that still believes there is potential for active fund management in India as the economy is still developing and we have a long way to go till the markets completely mature. We will see emergence of new businesses and growth of these businesses will be in line with the growth of the Indian economy in the long term. Thus, there is a strong case for active fund managers to generate alpha over long term period. Having said that, passive funds make a good investment option for retail investors who want exposure to equities but get confused when it comes to fund manager selection.”
He adds, “It is imperative for investors to invest in equities if they want to beat inflation in the long run. And, in the process of investment, fund manager selection is as important as selecting prudent asset allocation. Therefore, if an investor is able to review and select a fund manager they should choose active funds else passive funds becomes a default option that will provide the equity exposure.”
When asked about his thoughts on passive fund management in fixed income asset class, he says, “I think it’s a brilliant idea, reason being debt markets are less liquid compared to equity market. The ease of executing a transaction is higher in equities than in debt, thus Debt ETF will provide much needed ease of transacting to an investor. Also in equities the potential upside and downside are uncapped while in debt upside is capped to the coupon rate while downside is uncapped. In such a scenario, selecting a fund manager becomes very crucial for protecting the capital. Thus, it makes eminent sense for a retail investor to invest in Debt ETF.”
The concept of Debt ETF is likely to take some time to evolve. It will be interesting to see what sort of positioning it adopts in term of MOD (modified duration) and YTM (yield to maturity) and how the underlying benchmark is devised. On the other hand, Equity ETFs and Index Funds have evolved over past couple of years.
Let’s take a look at their characteristics.
Benefits of investing in passive funds
Investing in Index Funds is less energy consuming from an investor’s point of view. No need to track portfolio continuously, no need for understanding complex strategies and thus no need to go via distributor route. So investors can purchase any ETF/Index Fund and just sit back & relax while the money continues to grow.
Another major benefit is cost. Expense ratios of passive funds are way lesser than actively managed funds in the industry. The average difference between the expense ratio of actively managed funds and passively managed funds in India would range between 65-100bps (one basis point is 1/100th of a percentage). The portfolio churn ratio of these funds will also be lesser than the mutual fund schemes.
The drawback of investing in passive funds would be the opportunity loss. As in Indian markets, the probability of active funds outperforming the benchmark over long term is higher than that of other developed nations like US & UK. Also a fund cannot directly invest in the index. It has to buy stocks from the markets and that leads to a small mismatch in the overall returns known as tracking error. Investors should consider these aspects before investing.
RupeeIQ Take: The probability of higher wealth creation from actively managed funds is not yet ruled out in India; however, as markets mature the alpha generation will reduce. Passive funds come with great cost benefit as the expense ratios of these funds are lower and investors may do such investments directly (without intervention of an advisor which saves the distributor commission as well). Thus from futuristic portfolio building point of view, we think it makes sense for retail investors to allocate a portion of their portfolio towards the passively managed funds.