Let's look at two sets of indices. The first set comprises S&P BSE Sensex, Nifty, S&P BSE 500, Nifty Bank, S&P BSE Midcap and Nifty Next 50. The second set has benchmarks such as MSCI World Index, Indxx Blockchain Index, S&P U.S. IPO & Spinoff Index, S&P Kensho Electric Vehicles Index, Solactive Autonomous & Electric Vehicles Index and STOXX Global Electric Vehicles & Driving Technology NET Index.
Most mutual fund investors would be aware of the first set and would have at least one or two funds in their portfolios that would be benchmarked to these indices. The set comprises some of the most popular benchmarks, which have been in the market for long.
However, it is the second set which is in the news right now even though not many are aware of the benchmarks and the companies that are a part of these indices. Interestingly, these are global indices and typically have companies from various countries, but have suddenly become accessible to all Indian retail investors.
So what exactly has changed? In a nutshell, the world of passive investments, or passive funds, has opened up like never before. It started with new-age fund houses such as Navi Mutual Fund or Zerodha Mutual Fund, but traditional fund houses have been quick to catch up too. Simply put, passive funds are funds that replicate a particular index or benchmark. Index funds or exchange-traded funds (ETF) are the most popular examples of passive funds. For example, a Nifty Index fund of any mutual fund house would have the same 50 stocks in its portfolio that are part of the benchmark Nifty index of the NSE. Similarly, any Sensex fund would have the 30 Sensex stocks in its portfolio. Even the weightage of the stocks would mirror those in the index against which the scheme or the fund is benchmarked.
On the other hand, active schemes have a fund manager selecting stocks for its portfolio to generate an alpha—the quantum of return over and above the benchmark return. One look at the scheme documents filed with SEBI and it is crystal clear where the industry is headed.
A recent report by Finity, a fintech specialising in passive and direct mutual fund schemes, estimates that assets under management (AUM) of passive funds will cross Rs 25 lakh crore by March 2025, up from Rs 3 lakh crore in March 2021. In other words, it estimates that the share of AUM under passive funds will surge to 37 per cent of the total assets of the Indian mutual funds industry by March 2025, up from 10 per cent in March 2021.
The current year has already seen the launch of 73 passive fund schemes till the first week of December, as per data from Value Research, a mutual fund tracking firm. To put things in context, 31 such schemes were launched last year. In 2016, the number was 11.
More importantly, almost all fund houses—old and new—have launched passive schemes this year, which further corroborates the growing importance and popularity of the segment.
"Building an active fund management business is more challenging and it could be that passive is just a way to get started. The strategy is typically very specific to each fund house and there is no single right way to build a fund house or a fund management business," says Radhika Gupta, MD and CEO, Edelweiss Asset Management, which has an almost equal share of assets in active and passive spaces.
In terms of AUM, the mutual fund industry has seen the share of passive funds surge to 11 per cent of the total AUM in the quarter ended September 30, 2021. This share was just 7 per cent as on March 31, 2020.
In terms of folios as well, the growing share is quite visible, with nearly 10 per cent of the total folios belonging to passive funds as on September 30, 2021. This share was pegged at a meagre 3.3 per cent as on March 31, 2020, as per data from the Association of Mutual Funds in India (AMFI), the industry body of mutual funds.
Further, this increase coincides with the period when the share of individual investor AUM is rising, which only proves that an increasing number of retail investors are looking at passive funds. The share of individual investor AUM has risen from 13.5 per cent in the financial year ended March 31, 2019 (FY19), to 17.2 per cent in FY21.
Meanwhile, a report by Boston Consulting Group on the global asset mix of mutual funds showed that the AUM of passive funds was pegged at $22 trillion in 2020, which is expected to rise to $34 trillion in 2025.
"The beauty of passive is that wherever there is an underlying investible universe, you can create an index and thereafter a fund. Ideation has no limits and, hence, the plethora of funds," says Swarup Mohanty, CEO, Mirae Asset Investment Managers (India). Ideation is no longer possible on the active side as categorisation has been laid down clearly, he adds. Not surprisingly, fund houses are eyeing themes such as blockchain, robotics, US IPOs, semiconductors, electric vehicles, cloud computing, etc., to launch new passive funds. Sample some names of schemes in the making: Navi Blockchain Index Fund of Fund, Tata Global Semiconductor Fund of Fund, Motilal Oswal S&P U.S. IPO & Spinoff ETF, Nippon India S&P EV Index Fund, Mirae Asset Electric Autonomous Vehicle ETF Fund of Fund.
"The last couple of years have seen a lot of investor fund flow directed towards thematic products. Asset management companies are responding to that demand. There is also a plethora of thematic indices," says Ashwin Patni, HeadProducts, Axis Mutual Fund.
Earlier this year, an analysis by independent research firm Morningstar found that around 70 per cent of thematic ETFs in Europe outperformed global equities in the year to mid-May 2021. The best-performing thematic ETF in Europe was Invesco CoinShares Global Blockchain UCITS ETF followed by L&G Battery Value-Chain UCITS ETF and WisdomTree Battery Solutions UCITS ETF.
In India, the current calendar year has seen the launch of many thematic schemes, including Mirae Asset Hang Seng TECH ETF Fund of Fund, PGIM India Global Select Real Estate Securities Fund of Fund, Motilal Oswal MSCI EAFE Top100 Select Index Fund and HSBC Global Equity Climate Change Fund of Fund, etc.
Glass half-full or empty?
An interesting aspect of any discussion about active and passive funds is that the view could be contradictory, depending on business interests or the background of the entity. In other words, a fund house could present actual industry data in a way that it shows a majority of the active funds outperform their respective benchmarks, while a proponent of passive funds could present the same data to prove that a majority of active funds underperformed the benchmarks.
The latest India Report by SPIVA (S&P Indices versus Active Funds)—released in July this year—highlighted that a majority of large-cap, mid-cap and small-cap funds in the active category underperformed their benchmarks. "Despite a strong run-up in Indian equities in the first half of 2021, the majority of active funds in the large-cap and mid-/small-cap fund categories lagged their respective benchmarks, whereas active funds in the ELSS (equity-linked savings scheme) fund category fared better, in which only 36.59 per cent of active funds underperformed the S&P BSE 200," the report stated.
It further said that the equity large-cap category saw 86.21 per cent of active funds underperforming the benchmark in the one-year period ending June 2021, while for the ELSS category, the share of underperformance was 53.66 per cent. In the midand small-cap space, 58 per cent of the active funds underperformed the benchmark in the half-year period ending June 2021.
Simply put, the report by S&P Dow Jones Indices found that a majority of active funds underperformed their benchmarks. In sharp contrast, Union Mutual Fund, which has active funds in its bouquet of products, presented its analysis in November to show that most active funds have actually done better than their benchmarks. "The increasingly louder noise today would lead one to believe that active funds, on an average, underperform their benchmarks and do not justify the fees they charge. We have analysed the data and we have reasons to disagree," stated the report by Union MF.
It highlighted the fact that most analyses take into account the fund return as on a single date—mostly at the end of a particular month or quarter—and, hence, do not reflect the true picture. "Prevalent 'single date' performance analysis indicates that active funds do not outperform the benchmark. Rolling return analysis eliminates these biases and provides a more reliable insight in appraising fund performance. Rolling return analysis reveals that on an average, active funds in India have indeed outperformed their respective benchmarks," the report said.
To be active or passive is a debate that has been going on for decades, and this has only gotten louder in the recent past as the latter grew exponentially.
Fund managers, however, believe that the debate should not be an 'either/or' one as both categories complement each other. "There has been too much debate around active and passive funds, and the discussions seem to be skewed towards one versus the other. I think that debate is very premature," says Gupta. "The debate should be about equity penetration. Active or passive doesn't matter. There is enough space for both in everyone's portfolio. There are certain categories where active fits better and there are some where passive works better. I don't agree with the 'versus' debate," she explains. Hemen Bhatia, Deputy HeadETF, Nippon Life India Asset Management, agrees. He feels both categories can easily coexist in the market, and in an investor's portfolio, at various stages of investment. "If a first-time investor is looking to invest, he can just buy an ETF or an index fund. With just a few clicks, he can buy the whole market in the form of an index fund and that too at a very low cost. Simplicity and ease of investment attract many towards passive funds. Also, getting an alpha-generating fund manager is difficult," says Bhatia.
There is also a view that the growing popularity of passive funds will ensure that active fund managers perform to the best of their abilities, enhancing the quality and returns of active funds. "Passive funds are putting a healthy pressure on active fund managers to perform and generate a good alpha. Better-quality fund managers will be able to handle that pressure and deliver good returns, and the average or below-average ones will have a tough time," says Patni.
While the quantum of returns of a fund—whether active or passive—could depend on many factors, in terms of costs, passive funds typically score over active ones as their expense ratio—cost of fund management, marketing and other overheads—is lower compared with active funds. Patni, however, says, "A lower expense ratio can't be the driving force. Investors come to the market for returns and if they are getting better returns, then they are ready to pay a higher fee. The outcome is important, the fee is the secondary part."
Not entirely risk-free
The general perception is that passive funds are risk-free. But that's not the case as both active and passive schemes invest in equity that inherently has risks attached to it.
"Passive funds are not risk-free. If you are buying a small-cap index fund, it will have risks similar to a small-cap active fund. One needs to check the underlying factors. Is it concentrated or diversified? What is the tracking error and expense ratio?" says Gupta.
In the case of an active scheme, there is a fund manager safeguarding the investor's interest, says Mohanty. In a passive one, the risk of investing lies completely with the investor. "The investor is completely exposed to the losses (in a passive scheme). There is no one you can call and ask what went wrong, which happens on the active side," says Mohanty.
Simply put, any fall in the benchmark index would lead to a corresponding fall in the passive fund benchmarked to the index. For example, the Sensex fell from a high of 42,273.87 in January 2020 to a low of 25,638.90 in March 2020, and every passive scheme benchmarked to the Sensex would have felt the heat. Interestingly, passive funds could also pose a concentration risk in the market if a large number of schemes are benchmarked to a particular index—say, Sensex or Nifty—as all the funds of such schemes would be invested in those handful of stocks.
"I think factors like low cost along with simplicity and transparency in stock selection work for passive investing," says Registered Investment Advisor Vivek Damani. "However, the con is that these funds will be unable to beat the benchmark. So if you are happy replicating index returns, passive investing may be the way forward," he adds.
Whatever be the risks, the outlook for passive funds is quite robust. Between March 2016 and March 2021, the AUM of passive funds rose from Rs 22,409 crore to Rs 3.10 lakh crore, reflecting a CAGR of 69 per cent, as per the AMFI. "As underperformance in the active space increases, people start looking for themes and even futuristic mega themes... hence, we are seeing disruptive themes like robotics, cloud computing and EVs. Basic market cap-based funds will always be there, but one can do a lot through theme-based offerings," says Mohanty.
Bhatia, who has been involved with passive funds for over a decade, says, "As an increasing quantum of money flows into the markets and economies mature, it becomes all the more difficult for a fund manager to generate alpha."
For Damani, the main drivers of growth for passive funds will be digitisation, low expense ratio, innovation and increasing penetration. Interestingly, while the biggest NFOs (new fund offers) of India in terms of money collected have been from active funds, there is no denying that passive will grow exponentially from its current base and could even match the share visible in some of the more developed and mature markets.
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