As India’s stock markets, like those the world over, have come to be driven more by momentum and liquidity than underlying corporate earnings, the importance of stock-picking has declined, and investors are now increasingly going with Index-based instruments such as Exchange Traded Funds.
An analysis of the fund flows this year so far shows that a whopping 42% of FII’s total inflows into India’s public market in 2023 have been into into passive funds. That translates to a cool $6 billion.
Similarly, domestic passive funds have attracted inflows of $6.8 billion so far in 2023, representing 31% of overall mutual fund equity inflows in India.
These are historically high figures, as typically, such investments form only around 10% of the total.
Thanks to such strong inflows, ETFs now comprise 12.1% of total FII equity assets in India compared to 10.6% a year ago. BlackRock alone holds $37 billion in passive assets allocated to India. In terms of absolute numbers, foreign institutional investors’s total funds under passive management as of August has risen 22% on the year to $78 billion.
For domestic investors, this increase is 17% on the year, to $62 billion. In this category, however, there has not been a sharp increase in the proportion of funds under active management. Passive funds account for 17.1% of total equity AUM of domestic mutual funds, largely steady from 17.6% last year.
As per IIFL Securities, total passive equity assets under management (AUM) in India has risen 20% over the past year to $140 billion, forming 3.8% of total market capitalization.
Passive investing is the strategy of investing in funds that promise to follow a pre-fixed allocation of shares. For example, a fund may promise to have 10% TCS and 90% Infosys shares only.
They are of two types — ETFs or exchange traded funds, and index funds. Both are similar, except that the stock composition of the latter is based on the composition of the index that it is based on.
This shift is driven by several factors:
Lower Costs: Passive funds have significantly lower expense ratios than active funds as they do not require extensive research and stock picking capabilities. ETFs and index funds simply track an index, so the funds can be run largely by algorithms rather than fund managers.
For example, the average expense ratio of an actively managed large cap mutual fund in India is around 1.5-2%, whereas a Nifty 50 ETF charges only 0.1-0.2%. Over long investment horizons, these lower costs can compound into meaningful savings.
Superior Returns: Numerous studies globally have shown that active funds struggle to consistently outperform their benchmarks over the long run after accounting for fees. In India as well, a majority of large cap active funds have underperformed the Nifty 50 over 3, 5 and 10 year time frames.
Passive funds provide exposure to the broad market at minimal cost, giving investors a higher probability of generating benchmark-like returns. Rather than trying to pick winners, passive funds benefit from the long-term growth of the overall market.
Increased Correlations: In an era of abundant liquidity and low interest rates, stock prices have become more correlated and driven more by macro factors rather than fundamentals. When stocks move in tandem, stock picking becomes less impactful. As macro forces dominate, benchmark-matching returns through passive funds become more appealing than trying to beat the market through active stock selection.
Portfolio Diversification: Passive funds provide instant diversification by holding a basket of securities from an index. For example, a Nifty 50 ETF gives exposure to India’s 50 largest and most liquid companies across all major sectors. Such broad diversification can be difficult to achieve cost-effectively through direct stock picking.
Ease of Access: ETFs trade on the exchange just like stocks, so investors can buy and sell them easily through a Demat account. They provide a simple way to gain index exposure without the hassles of individually purchasing each constituent. Given their transparency and liquidity, passive funds are well suited to retail investors.
For foreign investors, passive funds provide a simple way to gain exposure to India’s growth story. Many global emerging market funds allocate 10-20% of their portfolio to India through ETFs.
India’s weightage in global passive funds has been increasing steadily. For instance, India’s allocation in Vanguard’s FTSE Emerging Markets ETF has risen from 12.8% to 18.7% over the past 5 years.
Foreign investors can ride the India growth wave without the need for extensive due diligence or monitoring of individual stocks.
For domestic mutual fund investors, index funds and ETFs provide a low-cost complement to active funds in their portfolio. Rather than trying to have unique perspectives on every stock, retail investors are recognizing the wisdom of just buying the broader market through passive vehicles.
