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Passive, active, inactive

An interesting new fund launch, but investors need to keep the active vs passive and domestic vs international issues separate

Passive, active, inactive

Mutual fund investors who track news about the industry would have learned a few days ago that a fund run in the US by Vanguard would soon be available for Indian investors. Those who are familiar with Vanguard and its legendary founder, John Bogle, would have been excited - justifiably so - by the news.

Of course, Vanguard is itself not starting any kind of an Indian business. Instead, the Vanguard Total Stock Market Index Fund, which is a US-based fund that is pretty accurately described by its name, will become available in India through a fund of funds (FoF). The FoF that will invest in it will be launched by a (sort of) new mutual fund company, Navi, which is backed by Sachin Bansal, one of the entrepreneurs who founded Flipkart and then sold it off to Walmart. Navi has decided to specialise in passively managed funds in the future and along with the Vanguard-based fund, has filed for SEBI approval for a total of 10 such funds. These are a mix of domestic and foreign funds.

Apart from the Vanguard name, none of this is particularly new. International funds have been available in India for decades, as have passive funds. Nevertheless, historically, there are few types of mutual funds that are simultaneously so useful as well as so ignored by Indian investors as international funds. We always knew that international diversification was an important element in any equity-investing plan but the pandemic has made it clear that this is a must. The advantage of international diversification, coupled with the cushion of the continuous exchange-rate advantage that the rupee's depreciation offers, makes foreign funds an easy choice to make.

The tax differential is a thing of the past too. For many years, the higher taxation on foreign equity investments was a problem. Returns from equity funds in India were zero tax but this exemption was available only to funds that invested in domestic equity. Returns from international equity funds were, at best, subject to 20 per cent tax after indexation. This gap has now closed because domestic equity-fund returns are now taxable at 10 per cent without indexation. That means that practically speaking, the tax disadvantage is gone. In fact, depending on the indexation, there will be many situations where you may pay less effective tax on foreign equity.

The bigger issue that remains is that of passive investing. Here, investors need to take a nuanced view. The case for passive investing in India is not quite proven yet. Let's quickly see what a passively managed fund is. Normal (actively managed) mutual funds aim to beat the markets, which is a way of saying that their aim is to have higher returns than a market index. In contrast, index funds - also called passively managed funds - aim to just replicate the performance of an index, neither better nor worse. They are based on the idea that fund managers can't beat the markets after costs are taken into account, or that it's not worthwhile to try and spot those few who do. Because index funds do not require fund management and research, they have much lower costs, which itself improves performance.

The case for passive funds is pretty much proven in the US, but not in India, not yet at least. However, in India, there is now a large fandom of passive investing which seems to think that whatever is true in the US must be true here too. Investors need to look at international investing and passive investing as two separate issues. Investing a certain proportion of your money in international funds is a must now and passive funds are a good option for international investing. Vanguard will be a new option in this area but there are many others which are equivalent.

However, all this has little bearing on your routine investing in normal Indian funds that invest in Indian equity. Well-chosen active funds are still the best option.