8 mins read . 26 Apr 2023
The legendary founder of Vanguard Investments, Jack Bogle, famously said, “Why look for a needle in a haystack, when you can buy the entire haystack.” Bogle was referring to the futility of stock selection. He underlined 2 reasons why passive index funds would do better than active mutual funds in the long run. Firstly, it is difficult for fund managers to consistently beat the market and when you cannot beat the market, what is the point of paying a higher cost for active funds. Secondly, even if there are a handful of managers that outperform the index, the probability that an investor can find such a fund manager and stick to that fund for a long time is quite low. Summing it up, the overall probability that an active fund manager can beat the market is low. That is why, India is actually seeing a shift towards passive funds in a big way. But, more on that later.
An interesting point to ponder is why do fund managers struggle to beat the index. After all, these fund managers have access to top-quality research, deep insights, and market intelligence. Despite these advantages, only 15-20% of equity funds in India beat the index on a consistent basis over the long term. It is hard to say why this happens, but there are 2 possible reasons for the same. Firstly, over time markets mature, so the advantage that you get from information and analysis becomes limited. For instance, there are scores of analysts tracking stocks like Infosys, Reliance, or Tata Motors. It is very unlikely that any important aspect of analysing the stock is left out. Secondly, there is the issue of Kurtosis. As per SEBI regulations, fund managers cannot allocate more than 10% to a single stock, so in the case of narrow rallies, fund managers lose out to the index.
The second point made by Bogle was the difficulty in finding and persisting with a winning fund manager. There are several reasons for this. Firstly, the probability of an index beating a fund manager is quite low, so even under normal conditions there is a low chance of your fund being one of them. While past returns appear to work in some cases, there is no guarantee that past returns reflect future performance in volatile markets. There is one more challenge that investors face. When a fund manager beats the index over the long term, it is not a consistent flow of positive returns year after year. There could be long phases of weak to negative returns, but later they average into above-market returns. However, investors often desert good funds in tough times. As a result, even with the right funds, they end up with lower returns.
To get a picture of how passive flows have panned out, we looked at last 3 financial years since the recovery post-COVID started in March 2020.
|Passive Funds||AUM (Mar-23)||AUM (Mar-22)||AUM (Mar-21)||AUM (Mar-20)||3-Year Growth|
|Fund of funds (Overseas)||22,991||22,609||12,408||2,734||740.82%|
|Passive Funds Total||6,97,522||5,21,928||3,21,626||1,65,235||322.14%|
Data Source: AMFI (figures in Rs crore)
Here we look at the AUM growth of passive funds between March 2020 and March 2023. The overall AUM has grown more than 4-fold from Rs1.65 trillion to Rs6.98 trillion. In this period, the index ETFs with an AUM of Rs4.84 trillion have emerged as the single biggest category of mutual funds in terms of AUM. The 20-fold growth in index funds is not just because of a low base but also because there has been a huge shift to passive equity and debt fund investing. There are some interesting overall trends that are seen here. Debt funds have seen interest in very long-duration lock-in, but others are preferring passive index bond funds. Even in equity funds, there is a preference for alpha generators like small-cap funds, mid-cap funds and thematic funds. However, investors are increasingly preferring passive equity index funds over large-cap funds, due to lower expense ratio.
Here is how passive fund folios grew between March 2022 and March 2023. Folios are investor accounts unique to an AMC and can be a good gauge of retail interest.
|Macro picture||Total Folios Mar-23||Total Folios Mar-22||Folio Growth|
|Fund of funds investing overseas||13,02,024||12,54,895||3.76%|
|Total of Passive Funds||2,19,19,004||1,85,07,554||18.43%|
Data Source: AMFI
What do we gather from the table above. Folios growth is visible, but for now, the growth in passive fund AUM is still being led by HNIs, institutions and corporates. That is why, the folios growth is not as impressive as it should be. But things would change once more retail investors start to appreciate the merits of passive investing through index funds and ETFs in debt and equity. After all, a lower expense ratio can make a big difference in a situation where outperformance is getting thinner by the day.
In FY23, passive funds saw total inflows of Rs157,489 crore, dominated by index funds and index ETFs. While index funds saw inflows of Rs95,671 crore, index ETFs saw net inflows of Rs59,256 crore across debt and equity. As a recent S&P study has shown, 88% of actively managed equity funds did worse than the BSE-100 index in 2022, and this ratio has deteriorated from 50% in 2021. Clearly, there is a targeted preference for passive funds and nobody is really complaining about it.