Here's why investors are increasingly turning to passive avenues like index funds and ETFs

But what makes Zerodha Fund House such a popular choice among investors looking at the mutual fund (MF) route is its unwavering focus on passive investing. It is India’s only purely passive MF company. However, the shift towards passive investing is evident across the industry. According to the Association of Mutual Funds in India (AMFI) data, the total AUM of all passive funds surged to more than Rs 9.34 lakh crore by March 2024, from Rs 83,000 crore at the end of FY18—an 11-fold increase in less than six years.

Passive investing has become increasingly popular in India in recent times. This investment style involves creating a fund portfolio that closely mirrors a market index. It is the opposite of active management, where a fund manager strives to outperform the market using different investing strategies. This hands-off approach of passive investing also results in significantly lower costs for investors. The average expense ratio of the Top 10 equity funds stands at 1.94%, compared to 0.30% for the Top 10 passive funds.

“If an investor is looking to participate in the sector’s growth without taking a call on the fund manager, then a passively managed offering is helpful. Over the past few years, investors have been increasingly embracing passive strategies, such as index funds and exchange-traded funds (ETFs), when it comes to exposure to benchmark indices. Going forward, this trend will gather steam,” says Chintan Haria, Principal—Investment Strategy, ICICI Prudential AMC. But investors should be mindful that passively managed strategies do not have the potential to generate alpha, he adds.

A study by Motilal Oswal Asset Management Company in August 2023 reveals that at present 61% of Indian investors have put their money in at least one passive fund, underscoring the fast-growing adoption of such funds in India. It says that passive funds have taken centre stage in India over the past few years, gaining market share—from 1.4% of the MF industry’s AUM in 2015 to 17% today.

Sharwan Kumar Goyal, Fund Manager and Head-Passive, Arbitrage, and Quant strategies at UTI AMC, cites low cost and simplicity to generate market returns (beta) and the fact that retirement funds invest 10-15% of annual accretion in passive funds as reasons for phenomenal growth in passive funds in the past 8-10 years. “We are also witnessing strong interest in these funds from distributors and retail investors in recent times,” he says.

Investing Strategies

Passive MF products typically come in the form of ETFs and index funds. Like stocks or debt securities, ETFs are traded on stock exchanges and replicate a particular index. A Nifty ETF that tracks the Nifty 50 index, for instance, will own the same stocks as the index and in the same ratio as their weighting on the index. Investors get to participate in the segments of markets they choose. One requires a demat account to invest in an ETF. On the other hand, index funds are like MFs, and they invest in popular indices such as the Nifty 50 or Sensex 100. Moreover, index fund investing does not require a demat account. However, they have higher expense ratios than ETFs, as they are primarily managed by fund managers.

Currently, index funds account for 23% of the Rs 9 lakh crore AUM of passive funds, ETFs for 74%, and fund of funds investing overseas for the remaining 3%.

ETFs, according to Goyal, are a good choice for those who understand the nuances of secondary market investing, are comfortable buying stocks, and have a demat and trading account, while index funds are a good option for those who are comfortable investing in MF schemes in the traditional way, which is through MFs. Although from a fund management perspective, they both help investors generate market returns.

Can different strategies be chosen for passive investing? Yes, ETFs allow investors to diversify their investments across equities, fixed-income options, and commodities markets. There are several funds available within each asset class. Investors have the option of investing in market cap-based funds such as large-cap, mid-cap, or small-cap. They could also play sectors or themes like banking, IT, consumption, etc., through ETFs.

There are also various strategies available within these asset classes. For example, some ETFs offer investors the opportunity to invest only in government securities, while others provide exposure to corporate bonds. Several innovative strategy ETFs, such as dividend yield and value, exist on the equity side, enabling investors to implement specific strategies.

“While it is true that most often the interest is limited towards benchmark indices-based offerings, at ICICI Prudential AMC, in 2023, we saw increased traction for smart beta strategies like momentum, alpha low volume and low volume. Also, sectoral offerings based on banks and IT saw investor interest,” says Haria of ICICI Prudential AMC.

Another advantage of ETFs is that one can invest more than 10% [of their total portfolio] in a stock, which is not allowed under equity funds. “In the case of ETFs, there’s no stock cap,” says Goyal; if the index has more than 10% weight, an investor can invest more than 10% in that particular stock.

The Fine Print

There are a few points to keep in mind while following the passive investment strategy. An ETF should closely replicate the underlying index. If an index has delivered 10% returns, the ETF return should also be similar. There is a metric called ‘Tracking Error’, which measures how close the ETF return is to that of the index. “Tracking error indicates how closely the fund is replicating the underlying benchmark. The smaller the tracking error, the better the investment outcome,” says Haria.

Next, check the expense ratio. The lower it is, the better for the investor. Then check liquidity. Market cap-based ETFs like Nifty, Midcap, etc. are more popular and have higher volumes. “Liquidity for ETFs is like water for fish; it’s critical that when investors attempt to buy an ETF on the exchange, there should be sellers, and vice versa. There should be sufficient trading volume in a particular ETF to ensure that the transaction happens at prices that are close to the price displayed on the exchanges,” explains Arun Sundaresan, Head-ETF at Nippon Life India Asset Management. “Liquidity, which is essentially good trading volume, is very important in the context of ETFs and would have a direct bearing on returns,” he adds.

Finally, while buying ETFs and index funds, consider the overall cost of ownership. In addition to AMC fees, investors also need to pay demat charges, broker commissions, and impact fees. Thus, ETF investors must be mindful of the total cost of ownership, while index funds have a bundled cost of ownership, meaning investors only pay the ‘total expense ratio.’

Given the recent boom in the Indian market, these costs may prove negligible when weighed against the returns from passive investing. So, if you are upbeat on the markets, passive funds can give your portfolio a big boost. 

@teena_kaushal