Time to go passive? | Value Research With their low cost and clear outperformance of active funds, ETFs and index funds have started to attract investor interest

Time to go passive?

With their low cost and clear outperformance of active funds, ETFs and index funds have started to attract investor interest

Until a couple of years ago, Indian investors buying equity mutual funds looked upon actively managed funds as their default choice without giving index funds a second thought. That was because trailing returns on actively managed funds across equity categories showed these funds convincingly beating their benchmarks.

But as active funds have struggled against their benchmarks lately, many Indian investors have begun to question if they should make the switch from active funds to passive funds and pocket some neat savings on costs. The unmistakable wave towards passive funds in the global context and the burgeoning variety of index products in India are adding to this interest.

Therefore, before jumping the gun to make a wholesale switch to passive investing, it is important to understand what's driving the recent underperformance. Three factors seem to be at play in active funds struggling against their benchmarks recently.

1. The total return effect
How an equity fund performs depends on what it is measured against. Until 2017, the majority of AMCs in India (except for a few like Quantum, Edelweiss and DSP Mutual Fund) used to benchmark their equity schemes against plain price indices instead of the total return indices.

But cottoning on to this shortcut, from February 1, 2018, SEBI decreed that all equity funds must benchmark themselves against total return indices rather than plain price indices. Given that dividends add about 1.2-1.3 per cent to the annual returns from indices such as the Sensex and Nifty on a yearly basis, this has whittled down one of the sources of spurious alpha for active funds.

2. Tighter mandates
A second regulatory tweak by SEBI which has made life more challenging for active managers is its recategorisation exercise in October 2017. Before SEBI reclassified all mutual fund schemes into 36 categories and laid down very specific definitions of where a large-cap, mid-cap, small-cap or multi-cap fund could invest, active fund mandates were loosely defined.

So in bull markets, funds that were 'blue-chip' by name as well as multi-cap funds could lean heavily towards mid and small caps to earn higher returns than their benchmarks. In bear markets, they could huddle in the safety of large caps.

By effectively tightening equity mandates and curbing fund manager excursions outside their mandate, SEBI's recategorisation has forced active managers to stick to their stated mandates. With opportunistic forays into mid and small caps cut off, some active funds have found it harder to beat their benchmarks.

3. Institutionalisation of the market
The third and more structural reason for the difficulty that fund managers face in outpacing the market could lie in the increasing institutionalisation of the Indian market. In the last five years, an increasing proportion of Indian retail investors have been routing their equity bets through professional money managers in mutual funds, unit-linked insurance and portfolio management schemes rather than directly dabbling in equities.

When equity ownership in a market is dominated by average Joes, it is easier for professional money managers to beat the market. But once the smart guys are forced to face off against each other, unearthing under-researched or mispriced stocks becomes tougher. This tends to trim their alpha.

While all the above factors have been whittling down sources of alpha for active funds, the management fees charged by active managers haven't materially reduced. With most active-fund categories averaging annual expenses of 2 odd per cent, fees take a good bite out of active fund returns vis-a-vis their passive peers, too.

A flash in the pan?
But while the above developments have clearly raised the bar for India's active managers to outperform the indices, passive investing in the Indian context is no cakewalk. Here are some factors that argue against making a wholesale shift to passive funds today.

1. Narrow index rally
Actively managed equity funds are evaluated against indices such as the Nifty 50 or Sensex on the premise that these indices are good barometers of the market. But what if these indices simply don't reflect market movements at all? This is what has been happening over the last three years.

The trailing three-year returns of 11.3 per cent on the Sensex (as on August 29, 2019) leave you with the impression that the last three years have been a breeze for Indian equities. But taking a deeper dive into the market, one finds that this is hardly reflective of what has really been transpiring.

Of the 500 stocks in the BSE 500 index, as many as 225 have delivered losses in the last three years. About 69 of these stocks have experienced deep cuts of over 60 per cent, while 126 stocks have lost over 30 per cent. By any ordinary measure, this would be a good
indication of the market being in a bear grip. But a handful of Sensex and Nifty 50 names have kept up the optical illusion of a bull market at the index level.

And this story is not only about the Sensex versus the rest of the market. Even within the Sensex, just six stocks (Hindustan Unilever, Reliance Industries, Infosys, TCS, HDFC and HDFC Bank, joined recently by Bajaj Finance) have propped up the index while others have languished.

2. Imperfect index composition
A second factor that Indian investors considering a shift to passive funds must evaluate is if the portfolio of companies that make up the key indices are indeed attractive from the perspective of long-term wealth creation.

The market-cap-based weights of most Indian indices and their concentrated positions in individual stocks and sectors make them less than perfect choices for a fundamental investor who has a 10- or 15-year time frame in mind.

3. Lack of efficient passive products
A third factor that works against passive investors in India, compared to their US cousins, is that both index funds and ETFs in India aren't yet as efficient as their global counterparts. For one, though the menu of ETFs listed on the bourses has been expanding, the majority of them feature dodgy liquidity.

Two, the low volumes also contribute to substantial mispricing of ETF units in the market, with the quoted price often trading at steep discounts or premiums to the NAV.

Three, the most successful passive funds globally are those which track broader market indices like the S&P 500 (Vanguard's success has been founded almost entirely on this index). However, in India, stock-market liquidity drops off a cliff beyond the top 150 stocks and index managers have found it difficult to run efficient passive funds that go beyond the top names in the market. Past attempts to run Nifty 500 funds have stumbled on high tracking error due to impact costs. While some AMCs, such as Motilal Oswal, are now launching new products mirroring broader market indices, their tracking errors bear close watching.

4. Recency bias
Finally, making large-scale shifts in your asset allocation or scheme preferences based on short-term return trends is what often leads to big bloopers in investing. Investment gurus warn investors to stay off the recency bias.

Given that the phenomenon of active funds lagging benchmarks is fairly recent in India, it may pay to give the benefit of doubt to active managers based on their long-term record. A year-wise comparison of the proportion of active funds beating market benchmarks across the large-cap, multi-cap and mid-cap categories suggests that active managers have faced such hiccups in beating benchmarks even in the past, only to make a comeback in subsequent years (see the graph titled 'Proportion of active funds outperforming their total return indices'). On this count, active funds in the multi-cap and mid-cap categories have fared better than those in the large-cap category.

Therefore, at this juncture, investors in active multi-cap and mid-cap funds would be better off staying away from passive alternatives and wait to gauge if the recent outperformance of the indices is a flash in the pan.

Based on the data though, active funds in the large-cap category seem to have more chronic problems in keeping up with their benchmarks. Here, investors can certainly consider adding Nifty 50 and Nifty Next 50 index funds to their portfolios, choosing them on the basis of low costs for better investment results.

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