Passive funds: The flavour of 2020?

Mutual funds have witnessed rapid growth in India over the past decade. In fact the growing popularity of mutual funds as an investment option is evident from the record inflows. Yet, the penetration of mutual funds is yet to catch up with global peers: India’s mutual funds penetration is pegged at about 11% of GDP, whereas it is 101% in the U.S., 57% in the U.K., 59% in Brazil, and 49% in South Africa. The untapped potential of this segment is testimony to the scope for development in the coming years.

As is true for most sunrise industries, the mutual fund domain has been subjected to a slew of regulatory reforms to safeguard the interests of investors as the industry evolves and expands. This has set the stage for funds to introduce sophisticated modes for investment as is clear from the range of NFO applications filed by AMCs for approval from markets regulator SEBI.

And, index funds, commonly known as passive funds, seem to be gaining traction. According to AMFI data, average assets under management stood at ₹1,82,398.34 crore versus ₹1,53,638.24 crore for large-cap funds in December 2019. Passive funds entail a much lower expense ratio in relation to actively managed equity funds and promise higher alpha generation to investors.

"We have seen good growth in the ETF market globally and in India. We believe that in India, data is suggesting that it’s getting difficult to beat the benchmark (at least the large-cap indices) for most funds (as low returns and costs are having a significant impact), but still few well-managed funds (including our large-cap fund) have been able to create decent alpha in this space," says Swarup Mohanty, CEO, Mirae Asset Global Investments India.

A. Balasubramanian, MD and CEO, Aditya Birla Sun Life AMC, says ETFs and index funds have attracted the attention of investors and advisers as they have managed to outperform actively managed funds. "Large-cap funds directly compete with index funds,” he says, adding that but the same funds outperformed the index “for the last 10 years or more, purely on the basis of stock selection coming from mid-cap space”. But this strategy did not go well in FY19. “One must also remember, given the vast size of the Indian market, it holds the potential of giving alpha over index over time, with a differentiated portfolio to index weights. As the market becomes mature, the same level of alpha generation would be challenging. Therefore, one should keep ETF and index as part of the allocation and consider it as complementary to actively managed funds," Balasubramanian says.

Fund managers believe there is a strong case for both active and passive funds to co-exist given the scope for alpha generation opportunities in the domestic market. "We continue to believe that managers who focus on time arbitrage and research arbitrage, and supplement these with behavioural edge will continue to generate alpha. In fact as passive funds become larger, their compulsion to mimic their benchmarks should also open up interesting opportunities for active fund managers to exploit," says Navneet Munot, CIO, SBI MF.

Currently, passively managed assets comprise less than 4% of the industry's total assets under management, but there is a marked shift in investors’ awareness about passive funds. "The industry penetration is quite high globally unlike in India where penetration and awareness are still low. In India, a large part of passive investments today are by institutional investors, mainly provident funds," adds Munot.