If you were to look at the October flows into equity funds, one thing that will hit you is the big shift to passive. Index funds and index ETFs saw flows of Rs.6,000 crore in October almost equal to the total flows of all equity oriented active funds. But that is not all. In the last five years, the AUM of passive index funds in India has moved up sharply from Rs.3,500 crore to Rs.1,85,000 crore and this figure promises to only grow further. The AUM of passive index funds in India is just about 6% of the total AUM compared to 35% in the US, but the shift has surely begun. Here is why index funds are attractive.
Impacted by volatility
To be fair, it is not just about volatility but about how the returns are getting concentrated in just a handful of stocks. For example, if you leave out TCS, RIL, HDFC Bank, ICICI Bank and HUVR, then the Nifty would have actually under-performed in the last one year. Active funds cannot concentrate their portfolio in a handful of stocks as it goes against the basic grain of diversification. The moment they have spread their holdings in this market, these active funds have underperformed. You just need to look at the numbers. In 2019, active funds earned a median return of 5.3% against 9.3% for the passive funds. In the year 2018, active funds had given negative returns while funds had yielded positive returns of 2.3%. This differential is driving money towards passive funds.
Regulations played a role too
In 2018, SEBI undertook a revamp of mutual fund regulations and one of the key areas was in MF classification. MFs were allowed to have only one category per AMC and each of these categories had to adhere to a strict definition. For example, a large cap fund had to have an exposure of at least 85% to large cap stocks. Mid cap funds had to keep an exposure of minimum 75% to mid cap stocks. SEBI even standardized the definition of large caps, mid caps and small caps by giving them a market cap related interpretation. This largely took away the leeway that funds had enjoyed in the past where they could tweak their holdings in search of alpha. This tighter regulation shaved off most of the alpha returns of active equity funds.
Costs matter in tough times
Nobody bothers about costs in heady bull markets but in tough times, these costs come home to roost. For example, the median cost (TER) of a regular large cap fund is around 2.45%. Even a direct plan of a large cap fund charges about 1.6% on an average. Compared to that, equity ETF has a TER of just 0.29%. This 200 bps difference between a passive fund and an active fund makes all the difference to the eventual net return. It does look like Indian mutual funds are seeing a gradual passive shift. Like the world over, Indian investors are lapping up index funds and ETFs! ©