Why is Passive Investing Gaining Momentum Now?

What Do We Understand by Passive Investing?

Unlike active investing, a passive investment just tries to mirror an index. The idea of a passive fund is not to beat the index through active stock selection but just to get returns as much as the index. The focus is purely on reducing the tracking error.

Passive investing is certainly picking up, and the proof is in the data. As of July 2023, the AUM of passive funds accounted for 16.84% of the total mutual fund AUM of ₹46.28 trillion. That is a lot of money in passive funds, including index funds, index ETFs, and linked funds like gold funds and fund of funds (FOFs).

Why Have Passive Funds Picked Up Sharply?

The study of mutual fund returns done by SPIVA (S&P Indices Versus Active Funds) for 2022 has come up with some interesting revelations:

• More than 85% of large-cap equity funds in India underperformed the S&P BSE 100 index over a 1-year, 3-year, and 5-year period.
• Over a 10-year period, about 65% of large-cap funds underperformed the index.
• The situation is slightly better for ELSS funds, likely due to the mandatory 3-year lock-in period.
• In mid-cap and small-cap funds, the percentage of funds underperforming the index is lower (under 55%), showing better alpha generation.

Key Reasons Behind This Trend:

1. Kurtosis Effect: If you look at the Nifty or Sensex, only a handful of stocks outperform. However, mutual funds are limited to a 10% exposure per stock, restricting their gains.
2. High Costs in Active Funds: The expense ratio in active large-cap funds is around 2.5% to 2.7%, while index ETFs have a TER of under 0.45%, making a significant difference in net returns.

As the Markets Are at an All-Time High, What Is the Scope for Higher Returns in Passive Funds Compared to Active Funds?

Passive investing, or investing in index funds and index ETFs, is not about outperforming active funds. Instead, it ensures consistent market participation with lower costs.

As Jack Bogle of Vanguard famously said,
"Why look for a needle in a haystack, when you can buy the entire haystack?"

Below is a comparison of major equity fund categories based on 1-year, 3-year, and 5-year returns (Category Averages):

Data Source: Morningstar India

The table highlights that index funds hold their ground against actively managed funds. If TERs are factored in, index funds may perform at par or even better than most active funds.

What Are the Factors an Investor Should Keep in Mind Before Investing in Passive Funds?

Index Funds Are Serious Passive Products

The purpose of an index fund is to mirror the index and provide market participation. Avoid funds marketed as “Beta Plus” or “Enhanced Index Funds”—these deviate from true passive investing.

Look at Costs Very Closely

Warren Buffett, in his 2016 Berkshire Hathaway annual report, commended Jack Bogle and Vanguard for providing low-cost investing opportunities to retail investors. Lower costs significantly improve long-term wealth creation.

Keep Indexing in Perspective

• Index funds should ideally be around 20-25% of your total equity exposure.
• A similar allocation can be applied for debt index funds in a diversified portfolio.
• Active funds still have a place in generating alpha over passive funds.

Indexing Is a Game for the Long Haul

A long-term perspective is key. The BSE Sensex has rallied from 100 to 60,000 in 44 years, delivering:

• A CAGR return of 15.5%
• An average dividend yield of 1.3%
• A total CAGR of 16.8% over time

This demonstrates how passive investing can build wealth steadily over decades.

What Type of Index Funds Should One Look at Now?

Broad-Based Index Funds

Investors can choose funds tracking large-cap indices like the Nifty 50 or Sensex. Other broad-based indices include:

• BSE 200
• NSE 500

These offer diversified exposure across multiple sectors and are ideal for stable returns.

Sectoral Index Funds and Their Risks

Some index funds track specific sectors like Banking, IT, or Financial Services. However:

• These come with higher concentration risk.
• Sectoral movements are cyclical, so timing matters.

Debt Index Funds and Their Applications

Debt index funds track government securities or corporate bond indices, offering low-risk fixed income options.

The Three Basic Applications of Index Funds

1. A Low-Cost Entry Point for New Investors

   • Ideal for first-time mutual fund investors.
   • Lower volatility compared to individual stocks.

2. Portfolio Realignment Tool

   • Investors can adjust asset allocation using index funds instead of trading stocks.
   • Great for reducing or increasing equity exposure without major transaction costs.

3. Avoid Timing the Market

   • Timing entry and exit in passive funds is futile.
   • A Systematic Investment Plan (SIP) in index funds allows investors to:
     • Benefit from rupee cost averaging.
     • Manage market volatility effectively.

Final Thoughts

Passive investing has proven its merit through cost efficiency, market participation, and consistency. While active funds aim to generate alpha, passive investing provides low-cost and long-term wealth creation. With markets at all-time highs, a balanced approach combining both active and passive funds can be the best strategy for investors.