Passive investing — An idea whose time has come

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Passive investing is at a nascent stage in India. While actively managed mutual fund schemes are closely tracked, rated and discussed on financial media, passive investing does not get due attention despite the simplicity and suitability of this investment approach for most investors.

By way of a quick refresh, passive investing is an investing strategy that seeks to mirror the portfolio of an index and therefore the returns of a particular index. Unlike actively managed funds, passive funds do not seek short-term opportunities in the market for profit.

Like many other investing approaches, passive investing is now making inroads into portfolios of Indian investors.

In the US, the passive mutual funds now contribute to more than 50% of the overall mutual fund industry AUM. The Vanguard 500 Index Fund, the first fund introduced in 1976 to mimic the S&P 500 index is still the largest, highly liquid and highly bought fund in the world even today. Time-tested index funds demonstrate the success of a passive investing strategy over the long-term.

Small but growing very fast

Index Funds and ETFs as a segment are growing faster the broader market as more investors develop an understanding of such products and an appreciation of them. In fact, this segment has grown by almost 24 to 30 times to close to Rs 2 lakh crore over the last 5 years ending June 2020. The mutual fund industry in comparison has doubled over the same period to Rs 25 lakh crore.

Despite this spectacular growth passive investing is not very popular in India with the total AUM of Index Funds and ETFs still comprising less than 10% of the overall mutual fund AUM.

The low-cost approach, the underperformance of active mutual funds and investor awareness over the years have led the passive segment to garner acceptance from the retail investor. Specifically, with the increased inflow from retail space over the last 12 months into passive funds, makes it no longer a niche product, though the majority still comes from institutional investors.

In India, with EPFO’s decision to invest 15% of its corpus in equities, a substantial part of organised pension money is flowing into the passive segment.

Sustained underperformance of actively managed funds especially in the large cap space versus their respective benchmarks is indicative of how tough an active fund managers’ job has become.

Direct Plans and fee only advisors are the key reasons for the growth of passive investing.

Indians have traditionally largely invested through brokers and these products pay little commission to distribution as compared to other mutual fund products. Hence, most of the time, passive investment products were not even  showcased to retail investors.

Since the introduction of no commission Direct Plans and with fee-based investment advisors willing to recommend passive schemes as an option to investors, this segment is seeing significant flows. The market regulator SEBI deserves credit for putting in the place the regulatory framework for both direct plans as well as for Registered Investment Advisers. Fund houses have also caught on to this and there are many index fund schemes now available compared to a handful just a few years back.

With increased investor awareness, digital transformation and underperformance of actively managed funds along with a shifting focus from fund selection to asset allocation as a pillar of financial planning, the passive investing segment is an idea whose time has come.

(The writer is co-founder and COO of Kuvera.in. Views expressed are personal)