Passive funds: Why Kotak is worried, BlackRock-Jio entry, and 2 key fallouts

Kotak Institutional Equities in a strategy note on Monday said it expects the share of passive funds in overall funds to rise rapidly if the domestic asset management industry was to continue in its present form. The brokerage said the increase in the share of passive funds is a global phenomenon, noting the relentless rise of passive funds is most visible in the US, which is the most vibrant capital market in the world. The same trends is expected to follow in India but with two key fallouts.  

Kotak said the rising share of passive funds in the overall shareholding of companies and the increasing ‘passive’ behavior of shareholders in India may dilute the two main roles of capital markets: Allocation of capital and pricing of capital. 

Passive funds or the unitholders of passive funds do not play an active role as shareholders of the underlying companies (stocks) in the passive fund. Passive funds can vote on resolutions of companies as shareholders but do not play the role of active shareholders for all practical purposes, Kotak noted adding that they are unlikely to engage with companies actively on any major issue (capital allocation, governance, strategy) given the mandate and the nature of the passive funds. 

"The unitholders of passive funds cannot play any role as shareholders of firms anyway since they are not even shareholders of the underlying firms in their passive funds. 

Kotak said an easy way to appreciate the problem of allocation of capital with passive funds would be think of extreme scenarios where a company is entirely or largely owned by a majority shareholder and passive funds only or a company is entirely or largely owned by passive funds. 

"Such companies could indulge in poor governance including misallocation of capital given lack of any checks and balances from minority shareholders. Such companies may also struggle to raise new capital from the market even if they were practicing good governance," Kotak said.

These, Kotak said, are not inconceivable scenarios since there are already some companies in India in the former category and these scenarios could play out if the relentless march of the passive industry was to continue, the broking firm said.

Besides, Kotak said passive funds or the unitholders of passive funds may distort the price of equities during periods of extreme market sentiment -- euphoria or depression. 

It believes retail shareholders may exaggerate the movement in stocks through purchase or sale of units of passive funds irrespective of prices and valuations of underlying stocks, as they are more likely to be swayed by the prevailing market sentiment.

A passive fund does not decide on the stocks and quantity of stocks to buy or sell beyond the stocks in the fund and their weights in the fund linked to some index. 

"We note that investment in underlying stocks in a passive fund is simply based on a formula (weight of the stock in the passive fund based on free-float market capitalization usually). A passive fund has to buy or sell stocks in the secondary market, as and when investors allocate more money to or withdraw money from the passive fund," it said.

Also a unitholder of a passive fund also does not decide on underlying stocks to buy, hold or sell. The unitholder is simply taking a top-down view that the unitholder will make an acceptable rate of return (expected rate of return) over a certain period of time. Such investment decisions to buy or sell units of a passive fund have very little
to do with the underlying fundamentals and valuations of the stocks in the fund, Kotak said.

BlackRock-Jio entry
Kotak said the entry of BlackRock-Jio with its focus on passive funds may accelerate the process, as other asset management companies may be forced to launch more passive funds to counter the disruption.  It said many of the ‘narrative’ stocks are now significantly owned by passive funds, which would suggest that sectoral or thematic passive funds that got launched later bought the stocks from the market to simply comply with the higher weight of such stocks in the benchmarks and not on the basis of the fundamentals of the companies. In other words, active funds divested the shares to passive funds.

Kotak said parts of the Indian active fund management industry may be starting to resemble passive funds given the structure of the market and design of the domestic fund management industry. 

"The compulsory investment or divestment linked to retail sentiment blurs the difference between active and passive fund management with (1) timing of investment, a crucial element of investing, being removed from the equation and (2) sector and stock
selection, the other key element of investing, being constrained by other factors of benchmarks, caps, competition," it said.

Kotak said large investments or divestments by retail investors into and from domestic equity mutual funds reduce the flexibility of the active funds to deploy the funds according to their views on fundamentals and valuations of the market and stocks. 

"The Indian market has seen continued large investments by retail investors in the past few years although the reverse phenomenon of large divestments has also been seen periodically during periods of panic due to domestic or global crises, which result in sharp and sudden loss of confidence in equities among retail investors," it said.