Passive funds are catching on rapidly in India; here is why!

The growth in the AUM of passive funds has been geometric in the last 5 years. In this period, the AUM of passive funds has grown 30-fold.

November 15, 2019 9:49 IST | India Infoline News Service
If you look at the big story of mutual fund flows in October 2019, the flows into index ETFs is almost as large as all the active equity funds put together. But this is not a stray trend. This has been progressively happening over the last six years. The chart below captures the explosion in passive funds AUM in India.

Chart Source: AMFI
The growth in the AUM of passive funds has been geometric in the last 5 years. In this period, the AUM of passive funds has grown 30-fold. One can argue that the base was small; which is a fair argument. But today, passive funds account for 6% of the total mutual funds AUM. This is still way below the 35% share that passive funds have in the US, but the growth over the last five years is surely gratifying. What is driving this sudden shift to passive funds in India?
Shortfalls in active fund performance
For a long time it appeared like Indian fund managers as a whole could do no wrong. At a time when global fund managers were struggling to beat the index, Indian active fund managers beat the index quite easily. However, the last two years have marked a return to reality. In the year 2018, the median passive equity fund generated 2.3% returns compared to negative returns by the median active fund. Similarly, in 2019 the median passive fund generated an average return of around 9.3% while the median active fund struggled to give 5.3%. That is a clear 400bps advantage. As passive fund managers have been getting it right for 2 years in succession, Indian investors are seeing merit in passive investing.
SEBI regulations too created a reality check for active fund managers
When SEBI revamped the mutual fund regulations in 2018, there was an important shift made in terms of reclassification. For example, a large cap fund had to necessarily have an exposure of 85% to large cap stocks. Similarly, a mid cap fund had to mandatorily have an exposure of 75% to mid cap stocks. Large caps and mid caps were defined based on the ranking of market caps. This meant that the erstwhile flexibility that fund managers enjoyed did not exist any longer. This brought about the need for fund managers to stick closer to their core fund charter and that impacted returns. Most funds tended to gravitate towards the group median returns and the scope for alpha became limited.
In the US, more than 85% of the large cap and mid cap funds underperform the S&P 500 index, which explains the massive interest in passive investing. In India, the situation is definitely better. For example, over a 10-year period, 63% of the large cap funds underperformed, but this went up to 88% over a 1 year period. Risks are surely mounting.
Why skewness is impacting mutual fund returns in India?
Skewness is the extent to which the stock performance diverges from the mean returns. For example, if in the 30-share Sensex, 7 stocks give positive returns and 23 stocks give negative returns, then the returns are skewed. That is exactly what is happening. The big five stocks like HDFC Bank, Infosys, TCS, RIL and HUVR are accounting for most of the gains. But fund managers can only hold so much in these five stocks. The moment they start getting into smaller private banks or autos or metals, the returns get skewed. That has been a major factor responsible for fund managers struggling to outperform the index. When just a handful of companies are outperforming, it is neither possible to pinpoint these winners nor is it possible to allocate the entire corpus to these stocks. That is why skewness is hitting the performance of active fund managers.
Above all, it boils down to costs

One key reason for passive funds outperforming is the low costs involved as depicted in the chart below.

Data source: AMFI
In the heady days of the bull market, investors hardly bothered about costs. But as the market volatility starts to bite, investors are gravitating towards substantially lower costs charged by passive funds. An active fund has to outperform an index ETF by 200bps just to be at par in terms of effective net returns. That is pulling investors towards passive funds.
Here is the macro view! India’s AUM/GDP ratio is currently around 7%. This compares with 91% in the US, 53% in Canada, 70% in France, 49% in Germany and 30% in Japan. Even China at 11% is better off. Going ahead, AUM growth will have to be driven by passive funds. That could be the space to watch out for!

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