Are Passive Funds Disrupting The MF Industry?

Are Passive Funds Disrupting The MF Industry?There are two schools of thought: one that favours active investing and one that favors passive investing. Between these two schools of thought, there has always been a tug of war. In the case of active-passive conflict, the differences of opinion are not just about cost, but also about alpha generation, and there is research being conducted all over the world in this regard. This story will provide you with insights into passive investing and how it is gaining traction in the mutual fund sector

There are two schools of thought in the realm of portfolio investing: one that supports active investing and one that supports passive investing. And there has always been a tussle between these two schools of thought in the mutual fund industry. This mental conflict is comparable to the one that exists between direct plan and regular plan distributors. However, the main distinction between the two is that in the case of active-passive conflict, the disagreements are not just about cost but also about alpha generation. However, in the event of direct-regular war, it is just a matter of expense.

Despite the fact that active investing is relatively prominent internationally, the increase in passive investments is groundbreaking. As of the conclusion of the fiscal year 2020, the worldwide assets under management (AUM) of actively managed funds totalled USD 51 trillion, accounting for around 49 per cent of the total global AUM. According to the BCG report, the contribution of passive investments to global assets was USD 22 trillion. According to a PwC analysis titled ‘Asset and Wealth Management Revolution: Embracing Exponential Change’, the worldwide AUM is expected to nearly treble by 2025.

According to PwC, funds under active management will increase from USD 60.6 trillion in 2016 to USD 87.6 trillion by 2025, while their percentage of total global assets under management will fall from 71 per cent in 2016 to 60 per cent by 2025. On the other hand, passive investments will earn a significant market share, growing from 17 per cent of AUM in 2016 to 25 per cent in 2025. The AUM of passive investments will more than double, rising from USD 14.2 trillion to USD 36.6 trillion. When it comes to India, active funds had a 39 per cent increase in AUM, while passive funds saw a 61 per cent increase. Furthermore, the compounded annual growth rate (CAGR) of passive funds over the previous three years was 52.4 per cent.

This clearly demonstrates that passive funds are gaining momentum even in India. According to figures given by the Association of Mutual Funds in India (AMFI), as of February 2022, institutional investors contributed about 90 per cent of passive assets while individual investors contributed 10 per cent. The proportion of institutional investors is larger due to investments made by the Employee Provided Fund Organisation (EPFO) and the National Pension System (NPS). However, the year 2021 might be dubbed the ‘Year of Passive Funds’ since, of the 131 funds launched, almost 45 per cent (59 funds) were passive funds. Even in terms of AUM, it provided 32 per cent of the AUM of the newly launched funds in 2021.

As previously said, there is always a struggle between two schools of thought, one believing in active investment and the other in passive investing. Various research studies conducted throughout the world demonstrate that passive investment is superior to active investing. S&P Indices versus Active Funds (SPIVA) score card is one such research. The SPIVA score card compares the performance of actively managed Indian mutual funds with their respective benchmark indices across one-year, three-year, five-year and ten-year investment horizons, according to the most recent SPIVA report of year end 2021. In this research, they examined the performance of three types of actively managed equity funds and two types of actively managed bond funds over one, three, five, and ten years ending in December 2021.

As seen in the table above, more than 50 per cent of actively managed Large-caps funds underperformed the index, while about 81 per cent of gilt funds underperformed the index. This demonstrates how actively managed funds failed to provide alpha. Let us now go to a more in-depth understanding of this.

The above two tables show information on the performance of index versus active funds. In the case of large-cap funds, more than 80 per cent of the funds continuously underperformed the index in terms of absolute returns in five years. Even in terms of risk-adjusted returns, over 70 per cent of the large-cap funds underperformed during five-year timeframe. In addition, during a ten-year period, 67 per cent of the large-cap funds underperformed the index. When it comes to equity linked saving schemes (ELSS), the maximum number of funds (nearly 80 per cent of the funds) underperformed the index over the five-year period.

Even across a three-year and ten-year timeframe, the number of ELSS funds underperforming the index is greater than 50 per cent. However, in the case of Mid-Cap and small-cap funds, things appear to be better since the majority of active funds are able to create alpha. In terms of actively managed Debt Funds, more than 80 per cent underperformed the index during a three-year period.This figure is much higher for actively managed gilt funds with over 80 per cent of the funds underperforming the index during the whole research period. This implies that when it comes to debt funds, going the passive route makes perfect sense.

The table above illustrates how many active funds survive after one year, three years, five years, and ten years. If we examine the same, we can see that as we approach towards a longer time horizon, the survivorship (percentage of funds that survive) declines, with gilt funds faring the poorest. As can be seen, just 40 per cent of gilt funds survived the ten-year term. Aside from gilt funds, the decline in survival of active equity funds intensifies as we approach a longer time horizon. Only ELSS funds outperform when it comes to survival. As a result, even the survivorship score demonstrates that debt funds and large-cap funds are more sensitive to poorer survivorship, and replacing them with passive investments would be the appropriate approach.

Passive Investment and Disruption of MF Industry
Passive investing increased in popularity during the years 2020 and 2021. This was the era when a wide range of passive funds were introduced, ranging from smart beta products such as momentum funds, low volatility funds, alpha-low volatility funds, quality funds, and so on to international funds. Indeed, we have begun to see passive investments in the fixed income (debt) area. Edelweiss Asset Management Company pioneered this with the introduction of Bharat Bond ETFs and FoFs.

Understanding Passive Investing
Passive investing is simply an investment technique in which the fund manager does not actively choose stocks from the benchmark index, but rather copies it. When compared to actively managed funds, this allows the fund to run at a reduced cost. This reduces the possibility of aggressive trading and fund manager bias. Furthermore, it is easier for investors to set reasonable return expectations because they will be earning market returns, subject to tracking error, in the end. There are some advantages of passive investing which via indexing is an excellent method of diversification. Maintaining a well-diversified portfolio is critical for successful investing.

The advantages are:
✓ Lower Cost: It is inexpensive since there is no fund management team to choose stocks. Passive funds track the index that serves as their benchmark. For example, the Nifty 50, the S&P BSE Sensex, Nifty IT, and so on.
✓ Tax Efficiency: Passive investing is a buy-and-hold approach that allows a fund to keep stocks over time. As a result, the investor will not experience a large capital gain within a year, resulting in tax savings.
✓ Transparency: Passive investing is relatively transparent in nature since the weightage of the companies in the index can be determined on a daily basis. However, in the case of actively managed funds, you must wait around one month to learn about its holdings in the previous month.
✓ Easy Implementation: It is relatively simple to deploy since it is a basic vanilla investment product with no human bias involved as the fund manager merely needs to duplicate the portfolio of benchmark index.

Furthermore, as new-age asset management firms such as Zerodha, NAVI, and others enter the mutual fund business with passive investing as their fundamental approach, and as more and more active funds underperform the index, the disruption is expected to occur in the near future. According to PwC and BCG research, even if the assets of active funds double by 2025, the growth rate would be reduced by nearly 60 per cent, while the same for passive funds will likely increase by 25 per cent. Moreover, according to the SPIVA India assessment for year-end 2021, a majority of active funds – particularly large-cap funds in the equities area and gilt funds in the debt space – underperformed the index.

However, this does not imply that you should abandon your active fund’s portfolio. The most you can do is swap out your large-cap and gilt funds for passive alternatives. Otherwise, active funds make more sense since mid-cap and small-cap funds as well as other funds that track certain sectors or themes may create considerable alpha above the index. If you are new to investing and have no past portfolio, having a proper mix of active and passive funds will not only help you manage risk better but will also help you decrease the total expense ratio of your mutual fund portfolio, allowing you to earn more returns.