Index ETFs bloom but retail investors still show active-bias

Over a five year period, the AUM of passive equity funds has grown from Rs7,000cr to Rs219,000cr.

Sep 28, 2020 08:09 IST India Infoline News Service

The months of July and August 2020 saw aggressive net selling in actively managed equity funds. Here, fund managers take continuous decisions on what to buy, what to sell and how to reallocate. But the one big story has been the emergence and growth of passive funds. By passive funds we are referring to index funds and index ETFs in India.

How passive index ETF flows have emerged in last 1 year?

Data Source: AMFI

The chart above captures growth in assets under management (AUM) of passive equity funds (index funds and index ETFs) over the last 1 year. If you look at month-wise data, AUM of passive funds is up 50% YOY; a phenomenal accretion in passive funds AUM. The shift in AUM becomes a lot starker if one looks at the data for the last 5 years.

Over a five year period, the AUM of passive equity funds has grown from Rs7,000cr to Rs219,000cr. This massive growth in passive funds has been supported by the Employee Provident Fund Office (EPFO), which was allowed to invest in equities via the ETF route. Their equity eligible funds of around Rs1 trillion is almost entirely invested in index ETFs and that has been a key driver of index ETF demand.

Interestingly, while the active fund AUM is still much higher compared to the passive fund AUM, the passive funds have emerged as the largest single category. These passive funds have been less vulnerable to outflows compared to active funds. In terms of AUM, key active fund categories like large cap funds and multi-cap funds have AUMs of close to Rs150,000cr each. This is sharply lower than the AUM of passive equity funds. However, the growth opportunity is still humongous as passive funds account for less than 8% of the overall mutual fund AUM, whereas in other countries it is well above 50%.

Big dependency on NSE indices

If you look at the overall AUM of the passive index ETFs, nearly 80% of these funds track either the Nifty or other NSE indices. This is more due to the comfort level that trading in NSE index futures has offered to traders due to its first-mover advantage. Out of the Rs2.20 trillion that is invested in index ETFs, nearly Rs1.75trillion is invested in NSE indices. The paradox is that the bulk of such monies come from institutional investors with the EPFO being one of the largest investors in index ETFs.

Institutions are active in index ETFs but retail investors are absent

The ETF space in India is dominated by institutions and will grow further on the back of EPFO, exempted PF trusts and insurance companies. That could be a positive and a cause of concern. Here is why!

Chart Source: AMFI

There are two things that clearly follow from the above graphic. Firstly, let us look at the active equity oriented schemes. 88% of its investors are individuals. These could be retail investors and high net worth investors or HNIs. That means it is the individual investors who are taking most of the active risk in the market and also contributing most to the TER (Total Expense Ratio) of the mutual funds; the biggest source of revenues for the asset management companies (AMCs).

On the other hand, if you look at the passive index ETFs and index funds, nearly 92% of the flows are accounted for by the institutional investors. Of course, this number is a tad skewed because the EPFO is only allowed to invest in the equity market through the ETF route and hence the institutional contribution looks high. However, the fact remains that the stake of individual investors in passive funds is very low at just about 8%. That is the major dichotomy.

Why this dichotomy between active and passive matters

Globally, it is passive investing that is attracting most of the retail flows. The reasons are not hard to seek. They are lower on the risk scale compared to active funds and if you factor in the lower costs of index funds, you have a solid value proposition in passive funds. That makes it all the more sad that individual investors are not participating enough in India.

The real imperative is that passive investing in India must gain traction among retail investors. Today, close to Rs7.85 trillion sits in actively managed equity funds in India and most of the money is retail money. This is despite the fact that passive funds have managed to do better than active funds in the last two years. In fact, an S&P Indices Versus Active Funds (SPIVA) report brought out in December 2019 highlighted that 82% of large-cap equity funds underperformed benchmark indices over a five year period. It is time for retail individual investors to look at index funds and index ETFs as a more serious component of their asset allocation.

Related Story

Open Free Demat Account (Rs699)