Big Picture. Why passive funds are in the news

The debate over investing in active versus passive funds has once again come into focus with the recent underperformance of actively managed funds in India. Over the past year, large- and multi-cap funds on average have underperformed their benchmarks by around 400 bps and 150 bps, respectively.

However, in case of equities, one year is too short a period to judge, and we should always evaluate performance over a longer time horizon. If we look at average returns over a five-year period, large- and multi-cap funds have outperformed their benchmarks by 100 bps and 200 bps annualised, respectively, and these returns are despite last year’s underperformance.

However, it is critical for investors to choose the right scheme. A case in point is that around a third of large-cap schemes have underperformed their benchmark over a five-year period.

Gauging the market

If we look at the market performance, year-to-date (YTD) the Nifty is flat. While the top six stocks have contributed a bulk of the positive returns, the rest of the Nifty stocks have dragged the index down. The broader market has seen a meaningful correction with the mid- and the small-cap indices declining almost 17 per cent and 30 per cent YTD, respectively. Among the BSE 500, more than 200 stocks are down more than 25 per cent YTD.

Last year was an aberration as the market performance was highly skewed, which happens rarely. This led to funds underperforming their benchmark, as funds typically have an overlap of only 40-60 per cent with their benchmark and hold a broader portfolio to generate outperformance. We believe that the narrow rally and its impact on performance is a passing phase. With improving macros, the broader market is seeing a revival and the divergence in performance is ebbing. Consequently, relative performance of funds versus their benchmark should improve.

Globally, in developed markets such as the US, more than 90 per cent of actively managed large-cap funds have underperformed their benchmark — S&P 500 — over a 15-year time-frame. Post the global financial crisis of 2008-09, almost $2 trillion was shifted from actively managed to passively managed equity funds, largely due to this underperformance. Currently, the level of passive indexation is around 45 per cent of equity fund AUM (assets under management).

However, high levels of passive asset base can create its own challenges. Concentrated investment in a few large index companies by passive funds can lead to distorted valuations and crowding out of smaller companies. It can also lead to higher volatility and an increase in systemic risk during a fall in the market.

Healthy prospects

In contrast to developed markets such as the US, actively managed funds in India have been outperforming their benchmark over the long term, with the past one year being an exception. Fund managers still have ample opportunities for generating alpha. For example, in case of large-cap schemes, the benchmark is the Nifty50 index, but fund managers can also invest in large-cap companies outside the Nifty which have given superior returns over the past five years.

Over the long term, mid-caps have given higher returns than large-caps, and fund managers can invest in high-potential companies in the mid-cap space. India being a growth market, several emerging companies get publicly listed every year and fund managers can invest in their IPO before these companies enter the index. Also, the Indian market is still not fully institutionalised.

Out of India’s total market capitalisation, FIIs (foreign institutional investors) constitute 15 per cent, retail investors more than 10 per cent, and mutual funds around 8 per cent. At times, FII buying and selling is driven by global liquidity rather than fundamentals — domestic fund managers can use this to their advantage. Swings in retail investor sentiment also contribute to market inefficiency, providing an opportunity for fund managers.

In India, passive investment products such as ETFs (exchange-traded funds) were launched in 2001. However, a notable surge in passive assets happened only over the past three years. With the government’s push, the Employees’ Provident Fund Organisation (EPFO) has invested up to 15 per cent of its investable assets — ₹50,000 crore — in ETFs. Currently, ETF AUM is around ₹90,000 crore, constituting less than 10 per cent of total equity AUM, and we are still in the early stages.

We do not expect any serious threat from passively managed funds in India, at least for the next five years. The historical post-expense outperformance of large- and multi-cap schemes has been 100-200 bps annualised. Arguably, this will compress over time. A like-to-like comparison for ETFs would be direct plans where the investor is taking a market exposure without any advisory. The direct plans of mutual funds already have an expense ratio 100 bps lower than regular plans. And with SEBI’s push, the expense ratio has been further reduced by about 20 bps. This benefit will cushion the actively managed funds even if we see a reduction in outperformance by 120 bps over a period of time.

A point to note is that alpha generation in multi- and mid-cap schemes will be higher than in large-cap schemes, but this is in line with the higher risk of those categories. Investors should always follow a portfolio approach for long-term investments and should own a basket of large-, mid- and multi-cap schemes.

The writer is Co-CIO,Aditya Birla Sun Life AMC

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