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The rise and rise of demand for passive mutual funds

27 Mar 2023 , 09:21 AM

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.

Fund 
Category

Feb-23 AUM
(Rs crore)

Feb-22 AUM
(Rs crore)

Feb-21 AUM
(Rs crore)

Feb-20 AUM
(Rs crore)

CAGR 
Growth

Index Funds

1,33,772 

54,737 

16,867 

7,930 

156.46%

International Fund of funds 

22,138 

22,072 

10,716 

2,724 

101.05%

GOLD ETF

21,836 

18,728 

14,102 

7,926 

40.19%

Index ETFs

4,87,067 

3,91,436 

2,73,886 

1,80,707 

39.17%

Grand Total

6,64,814 

4,86,974 

3,15,571 

        1,99,288 

49.42%

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.

Fund 
Category

Feb-23 
Folios

Feb-22 
Folios

Feb-21 
Folios

Feb-20 
Folios

CAGR 
Growth

GOLD ETF

46,73,999

37,74,398

10,89,710

4,92,753

111.68%

Global FOF

12,57,035

12,44,247

6,23,281

1,74,580

93.10%

Index Funds

33,89,328 

23,42,493 

9,36,077

4,76,834

92.27%

Index ETFs

1,18,54,687

97,85,826

39,42,779

17,66,536

88.62%

Grand Total

2,11,75,049 

1,71,46,964

65,91,847 

29,10,703

93.77%

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.

Related Tags

  • ETFs
  • MF
  • MFs
  • mutual fund
  • mutual funds
  • Passive Mutual Funds
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