Why Are More Investors Investing In Passive Funds?

Mid- and small-cap funds present a different picture and, hence, investors still prefer actively-managed funds.

Ever since the emergence of passively managed equity funds, the build-up in assets under management (AUM) in passives has been significant. This is largely due to performance-related issues. There are certain limitations in actively-managed funds, which weighs on performance. They have to have a cash component to manage redemptions. The corresponding benchmark, for example, the Nifty 50 or Sensex, is by definition always fully invested.

Sometimes actively managed funds take “cash calls”, i.e., deliberately have a part of the portfolio in cash, in a bearish market. However, in bull market movements, the cash call would be a drag on performance.

And of course, the expenses. An actively managed fund has to outperform the benchmark, net of expenses and outperform passively managed peers, net of the relatively-higher expenses.

However, there is a perception issue here. In index funds, whose job is to mimic the underlying index, they have a cash component to manage redemptions and a bit of expenses. There is a tracking error as well, as 100 percent correspondence with the benchmark is not possible.

In ETFs or exchange-traded funds, there is market price fluctuation. Hence, passives cannot beat the benchmark but the expenses are relatively lower than actives. In actives, the fund manager can avoid stocks with questionable corporate governance or ones with huge losses, which are part of indices by virtue of market capitalisation.

Small-caps beat their benchmarks by a mile

As per data sourced from MFI360 by ICRA Analytics, comparing actively managed funds with their total return index (TRI) benchmark, on a five-year point-to-point return comparison till December 31, 2022, only 8 percent of large-cap funds have been able to outperform their benchmark. On a daily rolling returns basis, only 10 percent of large-cap funds have beaten the benchmark. The scenario is different for mid-cap funds. In the five years to December 31, 2022, point-to-point, 43 percent of mid-cap funds have outperformed the benchmark, and 38 percent funds on a rolling return basis. The scenario is drastically different for small-cap funds. On similar parameters, 86 percent of small-cap funds have outperformed their benchmark.

What ails large-cap funds?

There are reasons for this dichotomy in performance between the market-cap categories. The universe of investment for large-cap funds is only the top 100 stocks. A mutual fund scheme, apart from index funds, can have a maximum of 10 percent in one stock. In large-cap benchmark indices, due to market price movements, at some points of time, the weightage can be more than 10 percent to a stock. This becomes a limitation for actively managed large-cap funds when that particular stock is rallying.

In contrast, for small-cap funds, the universe is wide. The fund manager has a wide canvas to paint—all the stocks beyond the top 250. The information and research asymmetry in small-cap stocks vis-à-vis large-caps presents the scope to fund managers to outperform the benchmark through stock selection.
Investor behaviour reflects the performance patterns mentioned above. As per Association of Mutual Funds in India data, large-cap funds had assets under management (AUM) of Rs 2.46 lakh crore in December 2022 and Rs 2.41 lakh crore in January 2023. AUM of index funds, which includes debt funds, was Rs 1.27 lakh crore in December 2022 and Rs 1.32 lakh crore in January 2023. AUM of ETFs, which also includes debt schemes, was Rs 4.98 lakh crore and Rs 4.92 lakh crore in December and January respectively. That is, passive funds other than gold are commanding Rs 6.25 lakh crore, including debt.

For granularity on the data and to make it comparative, we have taken AUM data from MFI360 by ICRA Analytics. Index funds and ETFs following large-cap indices like the Nifty50, Nifty100, Sensex, etc., had an AUM of Rs 3.59 lakh crore in December 2022.

The point is, large-cap-oriented passives with Rs 3.59 lakh crore command more than active large-caps, which have Rs 2.46 lakh crore.

There is one nuance in this data: passives include investments by the Employees’ Provident Fund Organisation (EPFO) which comes as a chunk. As an example, there is one Nifty50 ETF from a large asset management company, with a corpus size of Rs 1.52 lakh crore, based largely on EPFO deployment. On the other hand, actively managed small-cap funds had an AUM of Rs 1.3 lakh crore in December 2022 whereas passives following small-cap indices like the Nifty Smallcap 250 TRI have less than Rs 1,000 crore.

Should you go the active or passive way?

Passively managed large-cap funds have performed relatively better than actively managed peers, and command more money. It is the reverse for small-cap funds; actively managed funds have done better and command more money. Mid-cap funds are somewhere in between.

From your point of view, you may prefer passives for the large-cap component of your portfolio and actives for mid-cap / small-cap / theme or sector-based component, where the fund manager has scope to generate the outperformance.

Source: https://www.moneycontrol.com/news/business/personal-finance/why-are-more-investors-investing-in-passive-funds-10145011.html


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