Why Are Passive Funds In Vogue?

Discount brokerage firm Zerodha recently announced that it had been granted the final approval to launch Zerodha’s own asset management company (AMC).

Unlike most of India’s incumbent AMCs, that focus on both active and passive asset management, Zerodha’s AMC will focus only on creating passive investing products.

However, Zerodha is not the first Indian AMC to focus on passive fund management. Several new AMCs like Navi, NJ Wealth along with Zerodha, appear to have made passive investment products their primary product. The number of passively-managed funds launched in 2022, outpaced the number of actively-managed funds in the year.

A recent survey by Motilal Oswal shows the true extent of the growth of passive funds — the share of the industry's assets under management (money invested in passive funds) grew from 1.4 per cent in 2015 to 17 per cent.

Why Are Passive Funds Growing In Popularity

The growth of passive funds is not surprising in a market since active fund managers have failed at keeping up with the indices.

In 2022, more than 85 per cent of large cap fund managers failed to outperform the S&P Global BSE 100 benchmark. While a one-year comparison conveys little information, the under-performance is likely to grow as Indian markets become more efficient, and pockets of inefficiency become too small to be taken advantage of by large players.

In addition, the outperformances generated by actively-managed funds also come with a relatively higher fee — which has resulted in a large number of investors opting for passive schemes.

In recent years, there has also been an increase in financial literacy which has helped improve fund selection process for investors.

For instance, an unsophisticated investor might only look at the fund’s performance on a stand-alone basis, while someone with even basic financial literacy would compare the fund’s return versus the benchmark returns.

With active performance, investors have opted to shift into passive funds, which track an index and charge a low fee. Further, active fund performance is highly dependent on the fund manager and if a fund manager exits the fund, it might be difficult for the same fund to replicate its performance.

Fund houses also employ underhanded tactics such as merging under-performing funds with better performing funds to hide the extent of under-performance in its portfolio of funds. Style drift is another issue with actively managed funds, since fund managers sometimes try to change investment styles depending on the hot trends in the market.

Low Cost Drives Success Of Passive Funds

The two largest asset managers in the world are BlackRock and Vanguard — incidentally both are focused on the passive space.

Even other global asset managers like Fidelity have a large share of passive investments, whereas Indian fund houses historically have seen a high share of active funds.

A fund house that runs passive funds needs to keep costs as low as possible, since they are not selling a differentiated product. A low cost base would mean that they can charge a lower fee from clients, and differentiate themselves on the basis of cost alone.

Navi, for instance, has an interest expense of 0.06 per cent Navi Nifty 50 Index Fund Direct Fund, while an actively managed fund’s ratio would be anywhere between 0.5 to more than 2 per cent — as decided by the fund house in line with Securities and Exchange Board of India (SEBI)’s guidelines.

Recently, Blackrock and Jio Financial Services announced a joint venture to enter the asset management space. While the details have not been revealed yet, Blackrock’s presence could indicate that the joint venture would focus on passive funds, according to analysts.

Another new player in the segment, Bajaj Finserv AMC, indicated that it is interested in the passive funds management space.

India Still Has Place For Active Management

However, while passive funds certainly offer several advantages, shifting out of active funds into passive funds makes sense if there is chronic under-performance, style drift, or a change of fund manager.

The shift to passive funds also makes sense if one is investing for the long term, and does not have the resources to select funds.

Mere under-performance over a small period might not be a good reason to flip funds — a habit many retail investors suffer from. In addition, Indian markets are still not as institution-dominated as other markets are, and some pockets like mid, small and micro-caps, offer opportunities for investors to capitalise on.

While Indian large caps have high institutional coverage, in line with global standards, small-caps are under-covered by institutional brokerages — resulting in them mostly being overlooked by large players in the market.

According to a report, 75 per cent of fund managers in the USA underperformed over a ten year period (2009-2018) — the number which is far lower in India.

An average Indian fund manager would have delivered an alpha of 3 per cent over the same period, implying that India might still have place for active management.