The Mutual Fund Show: Why Investors Are Warming Up To Passive Funds

The main criteria for the choice of a passive fund is the category where one wants to invest, according to experts.

<div class="paragraphs"><p>(Source: Freepik)</p></div>
(Source: Freepik)

Passive funds are drawing interest from retail investors due to their low cost, simplicity and attractive market returns, according to experts.

"Passive funds are making the cut today from retail perspective, and people are looking at it from a much stronger lens," Pratik Oswal, head of passive funds at Motilal Oswal, told BQ Prime.

He listed three factors that are driving demand towards passive funds. "The number one is low cost. Passive funds are popular because more of your money is invested in the underlying funds ... because the expense ratio tends to be much lower. Apart from that, simplicity and market return is something which is also almost as important as low cost," he said.

According to Oswal, the overall assets under management of passive funds have grown to almost Rs 7.6 lakh crore, which is approximately 17% to 18% of the overall mutual fund AUM.

Criteria For Passive Funds

Anant Ladha, founder of InvestAajForKal, said the main criteria for the choice of a passive fund is the category where one wants to invest.

"Once you have decided the category, you can choose any reasonable fund with more than Rs 500 crore of corpus, a decent name, which has a legacy to take care of, and having tracking error of less than 0.7%," he said.

In The Mid-Cap, Small-Cap Space

According to Santosh Joseph, founder of Germinate Investor Services, for investors starting out, the Motilal Oswal Nifty 500 Index Fund can be a choice to capture the mid-cap and small-cap space in the passive side.

"You begin with that journey by getting a full-blown exposure to the top 500 stocks in the country," he said.

Ladha said the mid-cap and small-cap space have a lot of scope of outperforming the benchmark. After the new taxation rules on debt funds, even balanced and balanced advantage fund as a category have become very attractive, he said.

"You are giving your fund manager the choice to decide your allocation, and yet, you are trusting an expert," he said.

Watch the full video here:

Edited Excerpts From The Interview:

How would you describe the journey so far and where do we stand right now? 

Pratik Oswal: So, I remember a conversation that we had 3.5 years ago, and I think we are still somewhat in the same phase where I think one of the things that you know, we as an AMC and also a lot of other mutual fund houses are still talking about awareness.

I think even though we have seen a lot of funds flow to passive funds over the last 5-7 years’ time. To give some numbers, the overall AUM of passive funds was about Rs 20,000 crore in 2015 or 2016 and that's grown to almost Rs 7.6 lakh crore, which is now approximately 17% to 18% of the overall mutual fund AUM from about 1.5-2%.

So not only has it grown in size, but it’s also grown in market share, and I think what people think about passive funds they think about Nifty, Sensex but we have seen creation of new categories in this era or the last five years, you did not have fixed income passive funds five years ago, that's Rs 1 lakh crore industry today.

You did not see many commodities; you have gold and silver ETFs. You did not see international funds five years ago. So, I think what you see in industry is an explosion in a number of categories, number of funds and also in terms of the number of AUM that has come into the passive funds over the last five years.

However, having said that, most of the AUM that is coming in, is coming in through family offices, mostly institutional, from pension funds, but increasingly over the last couple of years, you are seeing a lot more interest coming in from investors from all sides. I think awareness is still the barrier, but I do think that over time, you will see less and less of that problem.

You asked a sample of investors what their approach to investing is, and that threw up a few very interesting results. So, what can you tell us about the headline from that?

Pratik Oswal: So, we actually did this very interesting survey and keep on doing surveys to understand investor preferences and how they sort of change over time, we obviously want to be more customer centric and what's really interesting is that we did this survey towards the start of the year, which we ran for about four months, we had about 3,000 to 4,000 responses in that survey.

What is interesting is that these are targeted towards mutual fund investors, not only from our AMC but from across the industry, and what we saw there is a lot more awareness, which was lacking when we had the podcast years ago, is currently a lot more than it used to be. So, approximately 60% plus of the participants said that they will invest in at least one passive fund, and most of them are looking at increasing their allocation towards passive funds going forward.

Not only that, there are obviously categories like factor funds, where people are now slowly being aware of and also most people in this segment are looking to increase their allocation towards passive funds over the next few months. So, I think the good thing is that majority of the investor base at least the investor base that we surveyed also overall on the end investors point of view.

Passive funds are sort of making the cut today from retail perspective, and people are looking at it from a much stronger lens. I think what has driven demand towards passive funds from an investor's perspective, the three main reasons I think, what investors have said in the survey.

The number one is low cost, I think passive funds are popular because a more of your money is invested in the underlying funds because the expense ratio tends to be much lower. So low cost is the number one reason and apart from that also simplicity and market return is something which is also almost as important as low cost.

So, I think what you have seen in passive funds, and we have lots of passive funds today, there are about 170, 180 funds, ETFs launched, or what you have seen is that the simpler products are getting most of the AUMs. So, I think simplicity and also low costs are the main reasons to why we are seeing so much interest in index funds ETFs.

I think you also asked about the ideal timeframe that people intend to hold these for?

Pratik Oswal: Exactly, and this is actually a very important thing because usually a lot of people tend to have trading strategies when they are buying bank Nifty or selling Nifty. But I think in our survey, what was really the good stuff was that most of our respondents were actually looking at three year plus perspective.

So, I think a lot of people looking at passive funds not from trading mindset but from an investing mindset, which I think is an excellent choice and also number two is, three or four respondents were actually looking at playing the space by SIPs, which again is great because SIPs is a great barometer, you don’t have to worry about the time in the markets and all of that.

So, I think the combination of the fact that most people are looking at from an investing lens, plus where people are looking at from a SIP lens is actually it's quite encouraging the way people like to invest in passive funds.

What current strategies do you think are interesting to talk about?

Pratik Oswal: So, looking at the U.S. we also feel that simpler products will get majority of it even. If you think about an index fund, the first that comes to most people's minds is the S&P 500 fund, which is very popular in the U.S., I think three or four of the largest fund in the world, are S&P 500 index funds, that's how popular that fund is.

I think even though obviously, the majority of AUM is there, just the size of the market is big enough so that there are many other billion dollar plus funds in the marketplace. So, I think that the way most AMCs including ours look at passive funds is, number one is building blocks for asset allocation and second is categories.

I think most people think of index funds ETFs as Sensex and Nifty, but actually you can have unlimited amount of passive funds. Most of these big AMCs in the U.S. have hundreds of index fund ETFs under their umbrella, and we will probably see similar sort of trends coming into India in the next five to 10 years’ time.

I also agree that the whole idea about passive is to be simple, but we, as an industry tend to overcomplicate a lot of things so there's a lot of factor funds and mid-cap funds, small-cap funds and multi-cap funds and micro-cap funds.

So, I think in terms of choice, there is a lot more choice than it was five years ago and as an investor I think the idea is that you're catering to different types of investors, you are catering to sophisticated investor, to retail investor, someone who is looking for different types of risk profile. So, I think, because we are catering to varied sort of set of investors, I think it's this category will approach to something that will probably stand out in India.

Having said that, most of the AUM should still sort of deal with simpler products. Your large caps, multi-caps, sort of funds or your fixed income, gold funds where majority of the money tends to go.

How does one look at passive to incorporate it? It's not necessarily something that should replace active completely, I'll start with you Santosh.

Santosh Joseph: So essentially, when one looks at the difference between the active and the passive, I think clearly, it's the easiest for the investors.

Now today we have grown with a new clutch of investors where we have gone from DIY, do it yourself to serve yourself. Now this product comes in handy for people who like to invest in equity, and at some level, are a little reticent to make a decision about should I go for active or passive, but still want to get their feet wet. This is a great way to start off.

So therefore, you don't have to really worry about should I do it or not do it, here an option is to both if you can, eventually you will graduate to either go full on active or you will be happy with passive.

Anant, I think a lot of people gravitate when they are starting large-cap funds, but there are several options across the spectrum, how do you choose?

Anant Ladha: See, I personally feel that index funds are perfect for newer investor who don't want to take anyone's help, be it IRS or be it mutual fund distributors. For example, if you want to invest in the U.S. market and you are not having much knowledge about U.S. market then probably index fund is a better option which you have to invest your money.

If you talk about India, I feel right now we still have a lot of scope in mid-cap and small-cap space where active funds will probably outperform for near future which we can see. So, for me index fund in India is mainly focused on the large-cap space. Maybe I am more attracted towards Nifty 50 equal weight funds because I feel that equally dividing your corpus in 50 stocks is something which is making more sense to me.

Even data suggests that whenever we see a five-year rolling return of any given time period, Nifty 50 equal weight fund has delivered more than 6% returns which is kind of we can say that you have outperformed or equally performed as compared to your FDs even in worst of the times.

So, this is one category which is attracting me the most right now. Other than that, especially in the mid-cap space and the small cap-space, I am more attracted towards the mutual funds and the active mutual funds.

Can also perhaps take the Nifty next 50 to kind of balance it out and to have an a reasonable allocation towards that large-cap space?

Santosh Joseph: As you go down that path of choosing between Nifty equal weight 50 or the Nifty next 50, I will just share some numbers for you, when you take within the Nifty, the top 10 stocks in Nifty alone constitute of 60% of Nifty.

Now with 50 stocks being in Nifty, the top 10 should be 20%. Whereas their weightage is 60%. You see the skew. Therefore, Nifty equal weight 50 may give you a fair chance because the top guy has got close to 10% in the Nifty and the bottom 50th guy has got about 0.5% percent. You see the skew and hopefully you are hoping that the guy at the bottom also gets a fair chance to perform to take Nifty forward.

Now therefore, Nifty equal weight 50 finds a little more merit than just Nifty 50 for the people who are happy not to make a decision. Now, I would like to extrapolate that out and say I like the Nifty 500. It's a beautiful universe, the universe in which most mutual funds operate, Active funds or not so active funds and even passive funds.

When you take the breakup 76% is large-cap, 34% is mid and small-cap there again, survival of the fittest. That story plays out beautifully. Again, this is for people who say I don't need anybody. I want to get my investment into the equities, but I do not know where whether you play equal 50, next 50 or Nifty 500, you got a beautiful paper I would root for a Nifty 500 if at all you want to go for active funds against the choice of a good active fund.

Santosh, are saying that you would argue, or you would bat for Nifty 500 index fund against quite a few actively managed funds?

Santosh Joseph: The reason is, their numbers are stacked against you. When you look at the universe of mid-cap and small cap. Even an average fund manager will beat the index.  I think we all agree on that.

Now when you want to build a combination of large cap, mid-cap and small cap, it will be easy to say that for large-cap and some bit of component, I will do passive and for small-cap and mid-cap I will do an active, then you know that's when Nifty 500 comes into play.

I am saying preferably play the active space, if at all you are so stuck up about saying no, I would like to play only passive then the 500 is a better choice. So, I think that's how I would like to put it.

Hypothetical scenario, one of our viewers has no knowledge of investing, wants to keep it simple, cost is low, what would your first suggestion be?

Anant Ladha: We should understand firstly, that whether it is investing or health matters, everything is subjective. We cannot have a single principle for everyone.

For example, I will just give you a very practical example. In the U.S. it is recommended that you should not consume a lot of ghee. It is not good for your health in terms of U.S. but when we come to India, we consume a lot of ghee, and it is actually good for our health because of the climatic condition which we have in India.

In the same way investing cannot be simple ABC. It has to be subjected depending upon your own personal tastes and your own personal mindset. If you talk about the initial starting point, and you don't want to take anyone's advice or anyone's help, I feel that DSP Nifty 50 equal weight fund is a decent fund having a tracking error of 0.05% which is reasonable and a decent fund to start off and it can be a starting point if you want to invest in international markets S&P 500 index fund be it of Motilal Oswal, or be it of HDFC, it's a good starting point and this is where you can start your journey.

Eventually I feel small-cap space and mid-cap space as I earlier also mentioned, you have a lot of scope of outperforming the benchmark and you will eventually need to have some knowledge about active funds or hire a distributor or an RIA and take his help and invest accordingly.

At the same time, especially after the new taxation rules which has applied on debt funds, even balanced and balanced advantage fund as a category has become very attractive because there you are giving your fund manager the choice to decide your allocation and yet you are trusting an expert. So, this is something you have to keep in mind. 

The argument, especially in the small-cap and mid-cap space, is that the active manager can help you protect your downside to a certain extent. How important is that?

Santosh Joseph: Well, to begin with, that entire notion of fill it, shut it, forget it is so good theoretically. But unfortunately, most investors go against their own principles of what they started out with.

Now you ask the question, somebody's watching the programme for the first time, and they do not know anything. For some reason, let's believe that Nifty equal 50, like what Anant said, was a great idea for him. But what's going to happen is they're going to be bogged down by the relative performance of the other funds or the market in general that they say.

Then they will question their conviction whether fill it, shut it, forget it was a great idea because you will see another active fund generating 2% extra return and you feel that you made a mistake by being passive, because you also have to understand any strategy whether active or passive, the true test is in your holding period, and the returns post holding period.

Now in an active fund, you have at least the objective to the fund manager will at least try to the best of his ability to avoid accidents or mistakes in the portfolio, which you can't because Nifty is a bunch of 50 stocks whether equal weighted or not equal weighted.

You pick the best and the worst in the group because it's an index, you have no choice about it but if it did, then your tracking will go for a toss and then there is no need for you to be in that kind of a category. Therefore, if investors truly stuck to their own internal mandates and conviction, fill it, shut it, forget it will work. There again, don't forget the time factor. If you give it 10 years, there will be very difficult for us to you know have these debates and passive as active because both will make money.

I think we are sure about that. The question is we do not have people with a 10 months’ time frame. April 1 to now we have got robust four-five months. Everybody's acidification has gone for a toss because now they are only talking about small-cap and mid-cap funds, forgetting about index and passive.

Anant, what else do you pay attention to? 

Anant Ladha: Tracking error is important, but it is not the only criteria. The main criteria when you choose a passive fund is to choose the category where you want to invest.

Once you have decided the category you can choose any reasonable fund with more than Rs 500 crores of corpus, a decent name, which has a legacy to take care of and having tracking error of less than 0.7%, it's good to go.

So, you first have to decide on what you want to invest, then everything will be sorted. Nothing to worry about, it won't make much of a difference. 

Santosh, what do you think?

Santosh Joseph: See, tracking is one mechanism to tell you whether the mandate of the fund is being honoured. Now in an active fund, you have a lot of measures that you want to see in terms of weightages of the stock, in terms of stock in, stock out churn ratio.

Whereas in a passive fund, you are looking at how the stocks are being replaced or how the stocks are managed in line almost using like a plumb line for construction, use a plumb line over here to ensure that the integrity of the fund for which you got in is managed because in a passive that is the only reason you come in that you are ensuring that the person in charge of the fund is managing the fund, but that can be measured through a tracking error, saying how quickly or how swiftly they are going.

But actually, if you think about it, you'll come to a passive fund, tracking errors shouldn't matter. Therefore, if you can, between one or two funds, choose the lesser of a tracking error, you're better off. It's not that if you got a slightly higher tracking error, you would underperform because then underperformance is so small, actually, you may not even figure it out.

Do you have a few names that you can suggest?

Santosh Joseph: So, I will always look at in the passive, how guys are making the entire space interesting. So, my favourite I think I have always already told you that, Motilal Nifty 500.

I think that is a great start for people to begin with because you don't miss out on the mid and small-cap even in the passive side. You begin with that journey by getting a full-blown exposure to the top 500 stocks in the country.

When you go down the order, I also see that you got the mid-cap 150, mid-cap 200 index, you also got I think UTI got a nice fund called the Momentum 30 in the Top 200 Index.

What we are saying is that adding the top 200 index but within that I choose only the 30 stocks to be in my portfolio. Otherwise, I think my favourite within Nifty space will not be the Nifty equal 50 or 50. I will go for the Nifty next 50 because you see there's a constant fight for who gets into Nifty and the fight is won by the guy who's the best.

So, in Darwinism, the survival of the fittest to enter into Nifty will have to only enter by two conditions, one he outperforms or two if somebody Nifty underperforms.