Going active on passive funds As a percentage of overall folios, passive folios have almost tripled over the last two financial years. According to a report by Finity, a fintech, the passive assets will grow to constitute 37% of the overall assets in the mutual fund industry by 2025.

Delhi-based Sameer Mediratta swears by passive investing. He has been investing in index mutual funds for the past seven years. "By putting my money in index funds, I am assured that I will get returns matched to the benchmark index if not less or more than that as in the case of active funds. Also, indexes over the long-run have grown tremendously and have been able to beat inflation. Passive investing works for me as it takes away the time and effort of choosing the funds," says Mediratta.

Like Mediratta, a growing number of investors have started taking the route of passive funds in the last few years. The numbers substantiate this. As on July 31, 2022, the size of the Indian mutual fund industry was 37.75 trillion. Of this about 15 % of assets were in just passively managed products alone, according to data by Association of Mutual funds (AMFI). This is a whopping increase of around four-fold in the last five years. As a percentage of overall folios, passive folios have almost tripled over the last two financial years. According to a report by Finity, a fintech specialising in passive and direct mutual fund schemes, the outlook of passive assets is strong. The passive assets will grow to constitute 37% of the overall assets in the mutual fund industry by 2025.

So, what has been the reason for a widespread interest in passive funds in recent years? It has been the disappearance of alpha, or active mutual funds' ability to derive excess returns over the benchmark index. According to the S&P Indices Versus Active Funds (SPIVA) India Scorecard for 2021, a majority of them have lagged their respective benchmarks. Half of the Indian large-cap equity schemes underperformed the S&P BSE 100 index in the year ended December 31, 2021 (over five years, 82 percent of the large-cap schemes underperformed the S&P BSE 100 index). In ELSS and mid-/small-cap categories 39.02% and 37.25% of the active funds underperformed their respective benchmark, respectively. Among mid- and small-sized schemes, the underperformance was 58 per cent over a five years period.

HOW TO INVEST PASSIVELY

There are two main routes of investing passive– index mutual funds and exchange-traded mutual funds (ETFs). An index fund works exactly like a traditional mutual fund scheme, except that the fund manager will buy and maintain the portfolio. For instance, a Nifty Index fund of any mutual fund house would have the same 50 stocks in its portfolio that are part of the benchmark Nifty index of the NSE. Similarly, any Sensex fund would have the 30 Sensex stocks in its portfolio. Even the weightage of the stocks would mirror those in the index against which the scheme or the fund is benchmarked. An ETF is also like a mutual fund, which holds a basket of securities, but is listed on the stock exchange. It can be purchased via a demat account.

"Since a passive fund is replicating an index, there is no fund selection by a fund manager and that risk is eliminated. Also, in some segments like the large cap category, the underlying companies are tracked extensively and information asymmetry is not available to exploit. Hence, fund managers in this category will not be able to perform better than the index," says Suresh Sadagopan, Managing Director & Principal Officer, Ladder7 Wealth Planners Pvt. Ltd.

CASE FOR PASSIVE FUNDS

Since the role of fund managers is limited in index funds, therefore the fund management charges are relatively lower. This results in a lower expense ratio than actively managed funds. The average expense ratio of index funds is 0.5-0.3% compared to 1.5%-2% for actively managed funds. While this difference may seem insignificant, over a long period these costs add up and are considered a significant factor in value creation over the long term.
The expense ratio becomes all the more important in case of debt funds because the returns from debt funds are relatively lower. And as expenses are deducted from the fund before calculating the NAV, it is likely to be a major differentiating factor among bond funds where returns vary marginally. Another advantage is that index funds offer diversification by investing in a basket of securities ranging from different sectors.

A VIABLE OPTION FOR FIRST TIME EQUITY INVESTORS

Experts recommend passive investing for those who want to take exposure to equities for the first time. "Beginners should in fact look at index funds as they take an overall position in a basket of equities comprising the index rather than investing in individual stocks. This would be very good for beginners and also for anyone who is not seriously into the market and putting in time and effort in understanding, acquiring knowledge and monitoring the landscape. They are a lower-risk choice as one need not know much about the underlying equities," says Sadagopan.

Besides first time equity investors, retirees too can include index funds in their portfolio. According to experts, they can invest the equity portion of their corpus in an index fund. "One cannot plan one's retirement funding with it. However, it can be a part of one's overall investment corpus to the extent it may be suitable in a retiree's portfolio. Typical overall equity exposure for a retiree is between 10-40% of the overall portfolio and index funds are a subset of this," adds Sadagopan.

WHAT TO KEEP IN MIND

While passive funds are low cost in nature, this alone shouldn't be the reason for going in for them. Index funds can lag their indices due to tracking error. The latter shows how well an index fund tracks the benchmark index during the investment period. A small tracking error means the index fund follows its benchmark index closely, whereas a higher tracking error shows the opposite.

"While considering a passive fund one should consider how well the scheme is replicating the underlying index, this can be seen by looking at tracking error and tracking difference. In fixed income index funds like target maturity funds, one should ensure that the maturity of the fund and their investment horizon should be aligned," says Niranjan Avasthi, head- Product, Marketing & Digital business, Edelweiss Mutual Fund.

TAXATION

Equity index funds are taxed like equity funds. Capital gains on units redeemed within the 12 months period are taxed as STCG of 15% and the units redeemed after the period of 12 months are taxed as LTCG of 10%. However, the LTCG on capital gains is taxed only on the gains which exceed INR 1 lakh per financial year.

NEWER CATEGORIES

First launched in India in 2001, the passive mutual funds have increased not just in numbers but also in terms of categories. On the back of strong demand from customers, both traditional and new age technology-based AMCs have launched many innovative passive schemes. Besides the option of investing in various broad market index funds like small cap, mid cap, large cap, etc, there are a number of options like equal-weight Nifty index, Nifty Next 50, factor based or smart beta index funds, market capitalization index funds, custom index funds and international index investing.

Also, the fund houses can now float a passively-managed ELSS fund after the capital markets regulator SEBI gave a nod for it recently. But they can either have an actively-managed ELSS scheme or a passively-managed one, but they cannot have both. Another requirement is that the passive ELSS scheme should be based on one of the indices comprising equity shares from top 250 companies in terms of market capitalization.

However, experts recommend going with popular indexes like Sensex, Nifty, Nifty 100, Nifty Next 50, and so on rather than obscure indices. "As compared to the typical index fund, there are certain parameters used to identify the shorter list. To that extent this will not be truly passive and will bring in some subjectivity into which companies come in the shortlist. I would prefer basic passive funds and choose factor investing when active choices have to be made," opines Sadagopan.

Adds Avasthi, "For core portfolio, market cap based index funds that track top 50, 100 and 250 stocks can be considered. Smart beta index funds can be considered as satellite exposure which can help in the diversification of style in the portfolio. On the fixed income side, simple target maturity funds can be part of the core
portfolio."