Is India primed for the Passive Investing onslaught?

Post GFC: 8 Great years for Passive Funds in US

Are we about to witness a similar trend in India Let us first take a look at the evolution of passive funds in the US

Post 2008: Relentless march of Passive Investing Post 2008: Relentless march of Passive Investing ...But 35 years after the launch of the first Vanguard fund 2008 GFC Dot Com bust Households’ net purchases of fund shares exceed those of corporate stock The Revenue Act of 1978 401(k)plans. Universal IRAs for all workers First ETFs are issued Investment Company Act of 1940 Vangaud started the first index fund Source: Investment Company Institute Factbook

Outperformance of Passive funds over the average active fund has fuelled the rally Money has consistently flooded into Passive funds from active over the last 10 years and not without reason Most actively managed fund returns have been trailing the Vanguard 500 Index Fund

In India, active funds still account for bulk of AUM and inflows Equity AUM of the Indian MF market is 4.75 lakh crore, out of which ~25,000 crore is in Passive (Index Funds + ETFs); incremental inflows seen in active funds Mutual Funds in India have generally outperformed their benchmarks across categories over the last 5 years (For 3.6lakh cr of 3.75 lakh cr of Open End Diversified Equity AUM) 44 of 48 Large cap funds representing 98% of AUM have beaten NIFTY 82 of 86 Diversified Funds representing 97% of AUM have beaten BSE200 28 of 28 Mid Cap Funds have beaten NSE Mid Cap Index Most of Equity AUM is held by retail investors though institutions like the EPFO have just begun entering the market through passive funds. To further understand the reasons for such outperformance, lets compare the structure of S&P 500 with the NIFTY Index – the only investible benchmark in India Total Equity AUM of 4.75 lakh cr. Arb AUM of 40Kcr, Close Ended AUM of 25kcr, Sector/Thematic AUM of 25kcr. Open end Diversified Equity AUM of 3.70lakh cr. Above analysis includes schemes with AUM of 3.6lakh cr.

NIFTY vs S&P 500: Stock Concentration Source: Bloomberg Source: Bloomberg Due to higher concentration, Index returns are influenced to large extent by the top 20 stocks (75% NIFTY weight) in the Index. For S&P 500, top 20 stocks form only 38% of the index Benchmark outperformance can be driven by active calls on the top 10 stocks due to their disproportionate weight. Going outside the benchmark has been a key driver of outperformance for active investors.

NIFTY vs S&P 500: Free Float Source: Bloomberg Source: Bloomberg Free Float factor for NIFTY Index is 53% vs 95% for S&P 500 Index. Profit contribution of each sector doesn’t reflect the weight due to the free float factor Infosys (4.5% of PAT but 6.0% of the Index) vs TCS (7.8% of PAT but 4.0% of NIFTY Index) HDFC Bank (3.8% of PAT but 8.1% of Index) vs SBI (4.2% of PAT but 2.6% of Index) Coal India (5.3% of PAT but only 1.25% of NIFTY Weight) For Active Investing: Higher promoter holding is a positive. For Passive Investing: Higher free float is critical

NIFTY vs S&P 500: Depth Source: Bloomberg Source: Bloomberg As per GICS classification, NIFTY covers only 22 distinct industries as compared to 61 covered by S&P 500. Also, top 3 companies of the sector in NIFTY constitute over 2/3rd of the sector weight as compared to top 3 stocks in each sector constitute less than 1/3rd of the weight in S&P 500. NIFTY as a benchmark represents only a small part of the economy and has concentration in few stocks & sectors.

Narrow indices not ideal for passive investing In an emerging economy like India, new sectors emerge every decade. A narrow index, by its construct is at a disadvantage to capture these shifts at an early stage. Span of industry coverage is limited in a narrow index. Concentration, stock as well as sector, in a narrow index more pronounced. Would a broader index satisfy the needs of passive investing?

NSE500 Index: A Viable Alternative? NSE500 is a broader index as compared to NIFTY but still more concentrated than S&P500. It covers 55 industries as compared to 22 for NIFTY But is it investible?? Source: Bloomberg

Inevitability: NSE500 not there yet Most broader indices like NSE500 don’t have index futures for hedging 192 stocks in NSE500 are covered by less than 5 analysts as compared to 8 in S&P500 Only 113 stocks in NSE500 are such that the value of their market capitalization gets traded annually as opposed to 485 in S&P500 There are 210 stocks in NSE500 for which the monthly traded volume is less than 6 million shares which is the volume of the least traded share in S&P 500. There are only ~150 stocks in India which have traded futures which help price discovery and hence make market efficient Source: Bloomberg

Are we putting the cart before the horse? India is still an emerging market where new sectors emerge every decade. Broader indices yet don’t have sufficient liquidity to be investible in terms of a passive strategy Promoter driven companies give the active investor the edge to bet on promoter ability Coverage of most analysts is limited to top 200 stocks resulting in lack of pricing discovery in the rest. In US, passive investing has emerged mainly due to higher proportion of institutional investors, coupled with lower Alpha of the average active fund over the benchmark

Like any inevitable change, it is not a question of ‘if’ but ‘when’. India too should see the wave of passive investing but only after More representative indices are designed Markets mature to a level that is closer to developed markets Alpha of the average active fund over the benchmark reduces Emergence of large institutional investors looking to gain only Beta exposure Like any inevitable change, it is not a question of ‘if’ but ‘when’. Passive investing may be the future but that future is probably 10-15 years away and not 3-5 years.

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