Let us start with a quiz comprising two questions. Firstly, which is the category of mutual funds in India that has the highest AUM. People may be tempted to believe that it would be liquid funds, since most of the corporate money goes there. The correct answer is Index ETFs. It is rather surprising that the highest AUM of nearly Rs5 trillion belongs to the passive category of index ETFs. Now for the second question. Which are the two largest asset managers in the world. The answer is Blackrock and Vanguard at first and second place. Between them, they manage $18 trillion (about 5 times the size of India’s annual GDP). Once again, both are predominantly index-based passive funds.

What is this attraction about passive funds in India?

As the name suggests, passive funds include index funds and index ETFs (exchange traded funds). The difference between index funds and index ETFs is that index ETFs are closed ended funds that are listed on the stock exchange and can be bought and sold like any other security using your trading account and stored in the demat account. Passive fund managers do not worry about stock selection. They just select a good index and benchmark their index portfolio to it. The only thing that passive fund managers worry about is to ensure that the tracking error is kept under control so that the portfolio of the fund reflects the underlying index as closely possible.

In its recent press release, NSE celebrated the rapid growth of index ETFs in India in the last 4-5 years, especially after the COVID pandemic. But now, for the million dollar question; why has passive investing taken off in such a big way in India too (we will look at real industry data later). Broadly, there are 5 reasons for this phenomenal growth in passive investing in India in recent years.

1. In the last few years, many equity investors preferred the passive route since active fund managers were struggling to beat the index on a consistent basis. For investors there were two challenges. Firstly, there is a success challenge since only 10-15% of fund managers beat the index. Secondly, there is also the low probability of finding and investing in such funds. Hence overall probability of beating the index was very low.
   
    
2. Cost has been a major factor for equity fund investors. If you look at the total expense ratio (TER) of an active equity fund, it is in the range of 2.3% to 2.5% of the AUM. That is a lot of money shaved away. In contrast, the TER of index ETFs is as low as 0.30% to 0.40%. Even if you add the brokerage and demat charges, it works out to be a lot more economical than active investing.
   
    
3. Thirdly, retail investors have started to see the merits of diversifying into other asset classes. It is not just about debt and equity indices. Passive investing interest is also picking up in gold ETFs and international FOF (fund of funds). These are new asset classes and investors are able to get access through passive platforms.
   
    
4. Then there is the institutional demand that is coming for index debt, which has been a growth area in terms of AUM, within the index ETF category. In the last few years, debt markets have become too volatile and investing in debt index assets not only gives stability but also reduces risk and cuts down investing costs.
   
    
5. Lastly, there has also been a major supply boost in the market and a slew of NFOs have also pushed demand. Under the new rules for mutual funds framed in 2018, an AMC can have just one fund of each class. Sector funds and index funds / index ETFs are the exceptions as there are no limits. That is where most of the supply is coming.

Intuitively, we know that there is supply of passive assets coming in and that is being met with enhanced demand. Having seen the reasons; is this growth for real and how have the AUM and the folios of passive assets growth in the last 4 years?

How passive fund AUM has grown in last 4 years?

The table below captures the growth in assets under management (AUM) for passive funds over the last 4 years, along with CAGR growth.

Data Source: AMFI

Growth in AUM has not just sharp in the last couple of years, but the CAGR growth of passive fund AUM between 2019 and 2023 has been an impressive 49.4%. Index Funds have led the way with 156.5% AUM on account of the slew of debt and equity index funds launched by private AMCs and the government. While the international FOFs have also seen sharp growth, it is on a much lower base. 

However, it is good that the AUM has been growing consistently over the last 4 years. Index ETFs have been really impressive since they account for bulk of the AUM of the passive category. Despite such a high base, the AUM of Index ETFs has grown at a CAGR of 39.2% in the last 4 years. Index ETFs are not just driving the AUM but also the retail and institutional interest in passive funds.

How passive fund Folios have grown in last 4 years?

The table below captures the growth of Folios (investor accounts) for passive funds over the last 4 years with the CAGR growth.

Data Source: AMFI

What stands out in the above table is that the CAGR growth in folios has been stronger than the CAGR growth in AUM. That is a good sign since it shows that retail investors are getting interested in passive products. Growth in AUM has not just sharp in the last 1 or 2 years, but the CAGR growth of passive fund folios between 2019 and 2023 has been an impressive 93.8%. Interestingly, it was Gold ETFs that led the way with 111.7% growth in folios as most retail investors appear to have taken a small exposure to gold as a hedge.

Among others, Global Fund of Funds, Index Funds, and Index ETFs have all grown at a  CAGR of around 90% in last 4 years. That is a substantial accretion to the folio count. Index ETFs constitute the bulk of the folios also in passive funds but other categories are catching up showing genuine retail demand building up. Folios are not just driving retail participation but also the AUM with a promise to grow exponentially once the tipping point is reached.

For a long time, passive investing never picked up in India since active funds were consistently beating the markets. That has changed as markets get tougher to beat. As Jack Bogle of Vanguard put it succinctly; “Why spend time looking for a needle in the haystack, when you can buy the entire haystack”. That message appears to be rubbing off on Indian investors and that is for the better.

It shows strong positive inflows across equity and passive funds, but outflows from active debt funds and hybrid funds. This replicates the trend seen in the September 2022 quarter. 

December 2022 marks the fifth consecutive quarter that active debt fund flows have been negative. This is indicative of the pressure of higher bond yields and diminishing attractiveness compared to alternatives. The December 2022 quarter showed a substantial bias in favour of passive funds followed by active equity funds.

As of the close of December 2022 quarter, net AUM of Indian mutual funds stood at Rs39.89 trillion, a gain of 3.81% over the September 2022 quarter. Although the flows into equity funds and passive funds were clearly positive, these gains were largely neutralized by the volatility in the equity market despite persistent FPI buying in the December quarter. 

The equity fund AUM accretion in the December 2022 quarter was triggered by net inflows. Despite the bounce in markets in October and November, the volatility of December put some pressure on equity fund AUM. Here is the story of mutual fund AUM in the December 2022 quarter and how the flows into specific categories of mutual funds panned out.

Debt fund flows in December 2022 quarter?

Indian debt funds saw net redemptions of Rs21,096 crore in the December 2022 quarter, which is much lower than the massive sell-offs seen March 2022 and the June 2022 quarter. The net outflows for December 2022 quarter appeared to stabilize and taper after the rates had been hiked by 225 basis points by the RBI and most of the downside risks were factored into bond prices. 

Let us look at key flow drivers and start with inflows? Only liquid funds saw substantial inflows in the quarter of  Rs39,509 crore. Among smaller inflows in the quarter, money market funds saw inflows of Rs2,030 crore, corporate bond funds Rs1,220 crore, long duration funds Rs559 crore and gilt funds Rs344 crore. Most of the other categories of debt funds saw either flat flows or strong outflows in the quarter.

The December 2022 quarter story of debt fund flows once again veered towards broad-based redemptions. Overnight Funds saw outflows of (Rs40,688 crore), Short Duration funds (Rs5,163 crore), Floater funds (Rs5,004 crore), Banking & PSU funds (Rs4,755 crore), Low Duration Funds (Rs3,148 crore), Medium Duration Funds (Rs2,618 crore) and ultra-short duration Funds (Rs2,290 crore). There were other redemption candidates like medium to long duration funds and credit risk funds, but they were relatively smaller.

Total AUM of all debt funds at the close of the December 2022 quarter stood at Rs12.42 trillion with its overall share of MF AUM lower sequentially at 31.82%. In the last one year, the big story has been the way, the equity fund AUM and the passive fund AUM have grown sizably at the cost of active debt fund AUM.

Equity fund flows in December 2022 quarter

After robust inflows of around Rs50,000 crore in each of the last few quarters, December 2022 quarter saw net equity inflows tapering to Rs18,952 crore. This is despite a sharp spike in the SIP flow numbers as well as the number of NFOs raising fresh funds. Unlike in the previous few quarters, several equity fund categories saw net outflows in the December quarter. 

This is despite steady flows from systematic investment plans (SIPs) and from new fund offerings (NFOs). One interesting trend that is visible in the December quarter is the general resistance among people in buying large cap funds as they are scouting for alpha in the mid-cap and small cap space. For the December quarter, large cap funds saw outflows of Rs(892) crore while dividend yield funds and focused funds also saw minor fund outflows.

The positive contributors to equity funds were a lot more affirmative. The search for Alpha has been more pronounced this time. Small cap funds led the quarter with net inflows of Rs5,205 crore, followed by mid-cap funds at Rs4,524 crore. Among other categories seeing positive net flows in the December 2022 quarter were sectoral & thematic funds at Rs3,862 crore, large & mid cap funds Rs2,972 crore, multi-cap plus flexi-cap funds Rs1,741 crore, value funds Rs1,173 crore and ELSS funds Rs696 crore. 

The total AUM of equity funds at the end of the December 2022 quarter stood at Rs15.25 trillion with a decisive market share of 37.81% marking a big shift in the last one year. In the December 2022 quarter 2 trends were visible. Firstly, there was a shift out of active funds into passive funds. Even within active, there was a shift from large index players into small and mid-cap stocks. However, equity funds have maintained the share lead over debt funds and widened the lead further in the December quarter.

Hybrid fund flows in December 2022 quarter

In December 2022 quarter, hybrid fund saw outflows after several quarters of net inflows and this can be largely attributed to selling in arbitrage funds as well as investors getting disillusioned with balanced advantage funds (BAFs). However, the NFOs that were driving record collection by BAFs were conspicuous by their absence. This resulted in the absence of incremental NFO flows into the Balanced Advantage Funds (BAF). 

Let us look at the inflows into hybrid funds first. Only multi-asset allocation funds saw net inflows of Rs1,884 crore in the December 2022 quarter. However, Arbitrage Funds saw net outflows of Rs(5,661) crore in December 2022 quarter, due to treasury considerations. Balanced Advantage Funds (BAFs) also saw outflows to the tune of Rs2,462 crore. Total AUM of all hybrid funds at the end of December 2022 quarter stood at Rs4.91 trillion, even as its AUM share in December 2022 has actually fallen marginally to 12.47%.

Passive fund flows in December 2022 quarter

Passive funds had another fantastic December 2022 quarter with net inflow of Rs36,053 crore, almost at par with the robust inflows in the last three quarters. There was traction across passive categories. Index Funds/ETFs saw inflows of Rs20,414 crore and other ETFs Rs15,600 crore. Gold funds saw tepid outflows of Rs321 crore while FOFs saw inflows of Rs359 crore. Passive funds now contribute a whopping 16.36% of total MF AUM. With most of the NFOs being dominated by passive funds, AUM growth is understandable.

To summarize the trend of the quarter, 4 trends emerge.

• Today, the fund with the largest AUM is not a debt fund but an index ETF that manages around Rs4.97 trillion. Liquid funds AUM is just Rs3.98 trillion.
• Closed-ended FTPs (largely through NFOs) have seen good traction in the December quarter as savvy investors rush to lock higher yields.
• There are two trends in equities. Firstly, there is a shift out of active into passive assets. Even in active assets, preference is for small and mid-cap stocks.
• Finally, it is the alternatives that have now emerged stronger with 30% market share. That is probably the road ahead.