Passive investing is a trillion-dollar business the world over. Across the developed world, passive funds have done as well as or, perhaps, better than active funds. The lower costs are a big advantage in case of passive funds, but in India passive investing is still to pick up in a big way. Not that passive funds have done too badly in India! For example, the Nifty index has given a return of over 18% CAGR in the last 22 years. If you add the average dividend yield, it will be closer to 19%, but despite that the concept of passive investing is still to take off in a big way.
Why has passive investing not taken off in India?
There is a large body of mid-cap stocks in India that have managed to substantially outperform the overall Nifty and the Sensex over the last 3 years. ETFs and index funds in India are typically benchmarked to the Nifty or to the Sensex. With no scope for adding mid-cap stocks to the portfolio, index funds and ETFs have been the less preferred option for Indian investors.
Considering that most of the alpha opportunities are in the mid-cap stocks then why cannot investors opt for passive investing in mid-cap benchmarks. The answer is that you do not really have a choice. Firstly, mid-cap stocks being extremely heterogenous by nature, it is hard to cast them into an index. Hence most mid-cap indices are not exactly representative. Most investors prefer investing in a mid-cap or micro-cap fund where you have the benefit of mid-cap stories plus the advantage of stock selection.
Direct plans have taken the sheen out of passive investing. One of the major advantages of passive investing is the lower cost in the form of fund management fees. This advantage was clear before direct fund plans were introduced in 2009. Under a direct plan, the investor directly goes to the fund and invests money, in which cases he is not charged the marketing and commission charges. This reduces the average cost for the investor by nearly 50 bps and reduces the advantage of passive funds substantially.
Lastly, in India investors still earn fairly attractive returns on fixed income investments. If you look at debt funds the total of interest earned and the capital gains in a dovish rate scenario can be as high as 11-12% per annum. When you pit this against an index fund or an ETF, the advantage is not substantial enough to justify looking at passive funds as a separate asset class in India.
Should investors look at passive funds in the Indian context?
Globally, the passive fund industry is a multi-trillion-dollar industry. In his last annual report of Berkshire Hathaway, Warren Buffett had specifically lauded the role played by John Bogle of Vanguard in helping small investors save billions of dollars in fees. Vanguard is the world leader in passive investing strategies. While passive investing may not be a great story as yet in India, it is likely to pick up in a big way in the coming years. Here is why..
With CPI inflation stuck at lower levels, it is likely that the interest rates in India will be headed lower. Already, Indian investors are moving away from bank FDs as the rates of return are just not remunerative. That will get more pronounced as interest rates settle at lower levels. Even debt funds will be just about able to better the FD rate as interest rates settle at lower levels. That should be a clear case in favour of passive investing.
Investing in equity via mutual funds investment has picked up in a big way in the last couple of years. In fact, in the last couple of years, the major equity inflows have come in through the SIP route and they have come in from second-rung towns and districts. For all these new investors, equity funds may not always be the outperforming asset class in all kinds of markets. Passive investing will offer them a low-cost method of participating in the equity market with limited downside risk and almost no risk of stock selection.
Passive funds need to be seen more as an asset allocation tool. Passive investing may not be a substitute to equity investing, but some part of the equity allocation can definitely be in passive assets like index funds and ETFs. This will not only result in a more diversified portfolio mix for the investor but also infuse less volatility in the investment.
When comparing passive funds with debt instruments and Fixed Deposits (FDs), one also needs to appreciate the tax treatment which is favourable to the index fund. That can make a substantial difference to the effective post-tax returns of these index funds.
Lastly, passive investing has attained a much higher level of sophistication in Western countries. These best practices are yet to come to India. For example, a large passive player like Vanguard is still not present in the Indian market. Western fund managers use sophisticated models to earn alpha in index funds and to minimize the tracking error. Once these best practices also come to India, it can be a better selling proposition for passive investing.
For a market obsessed with multi-baggers and long-term outperformers, the concept of passive investing is still quite alien. As interest rates fall further and equity return expectations become more rational, one can expect a spurt in demand for passive funds. When the alpha becomes much narrower in stock selection, then passive investing strategy comes into its own. India may not yet be there, but that trend of passive investing is likely to catch on sooner rather than later!