Moneycontrol Pro Panorama | Why investors are flocking to index funds

Dear Readers,

The coronavirus pandemic has structurally changed our lives. The way we live, work and think has all changed. The time at home was also spent in reading, educating ourselves and contemplating. It is perhaps this awareness that is also reflected in the way we invest.

Over the last year, mutual fund investing has seen a visible change. Investors have moved from active investing to passive investing.

In an actively managed fund, an experienced fund manager takes all buying and selling decisions based on his outlook of the market. Whereas in a passive fund, also known as index funds, stocks are bought and sold based on their weightage in the index. Passive investing is done through exchange-traded funds (ETFs) that invest in the index and do not require close monitoring. These funds mimic the performance of the indices.

Data from the Association of Mutual Funds of India show that the number of folios in the index funds has more than doubled from 1.014 million in March 2021 to 2.342 million in February 2022.

Watching the changing investor preference, asset management companies in the country have launched new index funds. Almost all big asset management companies like HDFC, ICICI, Aditya Birla Sunlife and Nippon Life, among others, launched new funds to capitalise on the change in investing patterns.

So, what led to this change in investing style?

One reason is the change in investor profile. Fintechs have gained market share in mutual fund distribution over the last few years attracting millennials to join the market for the first time. These tech-savvy investors could compare the difference in returns and cost between active and passive funds with the click of a button. Decision making then was not difficult.

Historically, most actively managed funds have underperformed their benchmark indices. A SPIVA India report comparing the performance of the active and passive fund shows that over one year, 86.21 percent of actively managed large-cap funds underperformed the index. And over five years, 82.7 percent of the funds underperformed.

The underperformance is visible in the bond market also where 97.87 percent of the funds underperformed the Composite Bond Index over five years. If one adds the cost involved in investing, the underperformance increases. A passive fund has an expense ratio of 6-20 basis points, whereas an actively managed fund costs around 60-125 basis points. In case of new funds or funds with a new sectoral theme like the ESG (Environment, Social and Governance) funds, the cost increases to over 200 basis points, closer to the maximum slab permissible. All the funds in this space have underperformed their benchmark index.

Over a longer term period, the compounding effect of this seemingly small cost results in a big dent in the returns for the investor.

For the asset management companies, the tectonic shift from actively managed funds to the passive funds is hurting their income. But they are to be blamed for this shift. Better performance by their fund managers would have prevented the shift.

Those investors who could calculate and see the difference in returns after including costs involved have smartly moved to passive funds. If underperformance of active funds continues, active funds will have a tough time justifying their existence.

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