Why passive investing makes more sense for retail mutual fund investors?

This article was originally published on this site

Retail investors tend to be attracted to the equity markets, not only due to the feeling of being part-owners of large companies but also because investing in equity shares can help beat the inflationary pressure by delivering a higher rate of return as compared to other havens. S&P BSE Sensex has generated more than 16% returns on an annualized basis over the past 42 years since its inception in 1978. However, the investments in stocks should be based on adequate research and conviction. This calls for spending time and efforts to undertake the companies’ fundamental analysis before making the investment decisions. This is where mutual funds emerge as convenient investment options to enjoy such exposure, as the investors can benefit from professional fund management.

Even within the mutual fund universe, the mutual fund schemes can be classified into two broad categories based on the investment strategies – active investing and passive investing. At the same time, active investing requires active decision making by the fund managers, passive investing tracks the benchmark indices and replicates the index composition into the investment portfolios. Such investing strategy confers on the rational price movement of the markets and believes in the theory that “markets know best” instead of focusing on the stock-specific decision-making. Since benchmark indices are built upon back-tested scientific methodologies and are reviewed periodically, it is believed that such indices will continue to generate the returns reflective of the market conditions. Investors understand the markets well, and passive investing makes it easier to understand the portfolio performance.

The Indian financial markets are continuing to evolve. As the markets mature steadily, the benchmark indices may continue to be well-representative of the market returns. As such, the Indian markets are fairly evolved and efficient now making it difficult for active schemes to consistently generate alpha. Passive schemes don’t allow the fund managers to make stock selections and change the stock weight in the investment portfolio. Thus, the role of fund managers in passive schemes is limited to tracking the underlying indices and implementing such changes in the investment portfolio. As such, passive schemes typically charge lower fund management charges, which translates into lower total expense ratios and in effect lower costs for investors. As the scheme expenses are eating into the investors’ returns, lower expense ratios help replicate the benchmark returns more closely for the investors. The investors can choose to invest in index funds and ETFs (Exchange Traded Funds) to benefit from the passive investing strategy.

With the increasing financialization of savings, mutual funds are emerging as a preferred investment option. This is reflected in the increasing AUM figure of Rs. 30.50 lakh crores as of 31 January 2021 (Source – Association of Mutual Funds in India) as against Rs. 23.37 lakh crores two years back in January 2019, translating into a 31% annualized increase. As against this, the AUM of Gold and other ETFs has grown significantly from Rs. 1.12 lakh crores to Rs. 2.72 lakh crores during the same period, showing an annualized increase of 142%. Therefore, the ETFs have captured 22% of the incremental AUM of the mutual fund industry over this period. Even the AUM of Fund of Funds investing overseas has increased from Rs. 1,823 crores in January 2019 to Rs. 9,847 crores as of January 2021. As such, the increasing preference of retail investors is visible towards passive schemes. The data regarding the monthly inflows into different schemes also reflects a similar trend, as the inflows into other ETFs in January 2021 were Rs. 6,133 crores second only to short-duration debt funds. This data will assume more importance, especially because the equity funds saw a net outflow of Rs. 9,253 crores during the same month.

While mutual funds are relatively under-penetrated with the national penetration levels lower than the global averages, the mutual fund industry continues to present investors’ with relevant investment options. The evolution of mutual fund schemes is not limited to active schemes but is also spreading towards passive schemes now. Passive investing is also not limited to exchange indices like S&P BSE Sensex, NSE Nifty50 but also extended to other popular indices. The investors can choose to invest in different passive funds, which track different asset classes, different sectors, indices for different investment strategies, etc. The investors can now also track major benchmark indices like midcap indices, large-cap indices, value indices, etc. As such, the investors can structure their passive investment portfolio with a wide range of choices, making it easier for them to align such a portfolio with their risk appetite and financial goals. With the inflows and AUM data for passive schemes like index funds, ETFs, FoFs, etc., it will not be wrong to conclude that while the ETFs are currently capturing only 9% of the industry AUM, their share is bound to grow further in the coming years echoing the trend in developed countries like the United States.

The low-cost nature of passive products coupled with their simplicity as an investment product, passive investing is indeed the way forward for retail investors.

(The writer is the Head ETF, Nippon Life India Asset Management)