Passive funds are growing: How you can benefit by investing in them

Demand and supply factors have led to the preference for passive funds

The assets under management (AUM) of passive funds have grown to Rs 10.2 trillion, while active funds stand at Rs 50.9 trillion as of June 2024, according to a study titled Where the Money Flows by Motilal Oswal Asset Management Company. Passive funds now constitute 17 per cent of the industry’s total AUM.

Key drivers of growth

Experts highlight that both demand and supply factors are behind the increasing popularity of passive funds. The Employees’ Provident Fund Organisation (EPFO) is a significant contributor to the growth of passive AUM, but individual investors are also increasingly favouring these funds.

On the demand side, the consistent underperformance of active funds has led investors to explore passive options. “They have started seeking options that at least match market returns,” says Vidya Bala, co-founder, PrimeInvestor.

Successive Standard & Poor’s Indices Versus Active (SPIVA) reports have underscored this trend of underperformance in active funds. About 62.1 per cent large cap funds and 75.4 mid and smallcap funds underperformed their benchmarks over the 10-year period, according to the SPIVA India 2023 year-end scorecard.

Two key developments have reinforced this shift. “First, the Securities & Exchange Board of India’s (Sebi) new categorisation rules limited the flexibility fund managers had previously. Second, the adoption of the Total Return Index (TRI), which includes dividends, as the benchmark further accentuated this trend,” says Bala.

The rise of direct plans from 2017-2018 onward also played a crucial role in shifting investor focus. New mutual fund apps promoting direct plans highlighted a potential 1 per cent cost saving by investing directly, which led retail investors to pay more attention to the total expense ratio (TER).

“The direct plan movement made retail investors more cost-conscious. They realised that by opting for passive investments, they could reduce the expense ratio even further,” says Ravi Saraogi, co-founder, Samasthiti Advisors.

On the supply side, asset management companies (AMCs) have responded to Sebi’s restrictions (one fund per category) by launching multiple index funds and exchange-traded funds (ETFs) that track unique indices. 

“Sebi allows AMCs to launch several index funds or ETFs as long as each tracks a different index,” says Bala.

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Core portfolio: Look for stability

The core of any portfolio should provide stability, akin to a ballast that provides stability to a ship in rough seas. “Largecap exposure is ideal, as largecap stocks are generally less volatile than midcap and smallcap stocks,” says Saraogi. He adds that for largecap exposure, he prefers passive funds over active because data shows that active largecap funds often struggle to outperform their benchmarks. He suggests funds based on indices like the Nifty 50, Nifty Next 50 and Nifty 100. Those who prefer to use a single fund may go for one based on the BSE 500 or the Nifty 500.

Market cap based index funds tend to be growth oriented. “To complement them, investors may include a value-oriented fund, low volatility and/or alpha low volatility,” says Bala. When used in the core portfolio, a value fund must be a long-term allocation.

Satellite: Include return-enhancing strategies

Once a solid core is established, investors can consider taking calculated risks in the satellite portion of their portfolio in the quest for higher returns. The contents of the satellite portfolio should align with individual risk tolerance, timeframe and investment goals. Sector or thematic funds, along with certain strategy-based funds, might be appropriate choices.

“A value-oriented factor fund may be part of the satellite portfolio when it is being used by someone tactically to capture the market’s tendency to favour growth and value strategies alternatively,” says Saraogi.

Momentum-based strategies, being inherently volatile, are better suited for the satellite portfolio. “Momentum strategies can yield high returns but may underperform during sideways or declining markets, making them more appropriate for the satellite portion,” says Saraogi.

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Sector and thematic funds: Exercise caution

While there has been a surge in the launch of sector and thematic passive offerings in recent months, experts advise caution. “Investors should mostly avoid these funds due to the concentration risk they introduce,” says Saraogi.

These funds come with inherent timing risk. “Their returns can be volatile and unpredictable. There’s a significant risk of entering too late and missing out on returns. Getting the entry and exit timing right consistently is difficult,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Advisor. Only well-informed investors with strong conviction in specific sectors or themes should consider these funds. They should place them in the satellite portion of the portfolio.

Role of factor-based passives

These funds can either substitute or complement active funds and market cap based indices. “If you believe that your portfolio is lacking in a certain factor, such as value, quality or momentum, get it through a factor-based fund,” says Belapurkar.

Saraogi favours going with a single-factor fund rather than complex, multi-factor funds. Like sector and thematic funds, factor-based funds (especially the single-factor ones) also run timing risk.

Multi-factor funds can at times be the product of data mining. Go for them only if they have performed well in life conditions. Finally, to achieve the best outcomes, consider a mix of passive and active funds (include the latter if you have the necessary risk appetite).

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Criteria to apply when selecting passive funds

> Vintage: Prefer funds with at least three years of history so that metrics, such as tracking difference and tracking error, are available
 

> Tracking difference: Measures the gap between the fund’s return and the index it replicates
 

> Tracking error: Shows the standard deviation of the variability in the difference between the daily return and index return

> Assets under management: Favour funds with larger AUMs to ensure economies of scale, better deals with broker, and efficient replication of the index; prefer one of the top three or four funds by size

> Liquidity: In case of an ETF, compare the trading price with the iNAV: If you buy at a significant premium, or sell at a significant discount, it could hurt your returns