When I read Aswath Damodaran’s recent blog “Active Investing: Rest in Peace or Resurgent Force?”. I remembered a blog I wrote on Indian Mutual Fund Industry. There was a small piece in it about passive investing not being successful in India. So, I thought to dig deeper from the Indian perspective.
Dawn of passive investing in India
Largest ETF today is SBI Nifty 50 ETF with ~Rs. 9k cr as AUM but this fund started more than 20 years ago. This clearly shows ETFs in India are still in very nascent stage. In India, a passive investment in Bonds is almost non-existent and for real-estate both active and passive is minuscule.
Above chart shows that ETFs are becoming famous in India in last 2-3 years but are still at below 5% levels similar 1995 number for the US. So, for passive asset management to become relevant in India it will take at least a decade or two.
Another thing that I observed is that Corporate and Banks are warming up to ETFs whereas Retail and HNI which accounts for 80%+ of equity investments in MFs and ETFs are only invested ~0.5% of their AUM via ETFs.
Now, from above analysis it’s clear that only corporates are biting into ETFs by HNI and the Retail segment is still far away. The question is now why HNI and the Retail segment is not shifting to ETFs. Both these segments are mostly driven by historical performance than anything else.
Not a Right Time Yet
Passive investing in the US is flourishing but it looks very different in India. The major reason behind this is that Equity mutual funds in India are still generating significant alpha contrary to below index returns by their US counterpart. Honestly, the only reason for this to happen is that there are bigger fools in Indian stock market be it a Retail investor, FII, etc.
1) In India, active investing has outperformed passive investing
To be honest, I don’t really know the exact reason for this. But my bet is that Indian market is still in a nascent stage and hence it provides an opportunity to fund managers to make higher returns by better stock selection, allocations and most importantly timing. Unlike, US markets where DII’s accounts for the majority of the market, the Indian market has a lot of different players from Retail, HNI, FII, etc which creates a possibility active investing to outperform.
- Median Returns for ETFs/Index funds with AUM > Rs. 50 Cr (29 ETFs)
- Median Returns for Equity MFs with AUM > Rs. 100 Cr (212 MFs)
- Returns of only Regular MFs considered
Above chart clearly show that in India, active investing is outperforming passive investing across all time periods not only during the downturn. Also, I looked at the whole relevant universe. In future, this might change but I expect that future to be at least a decade away.
2) All sub-segments have outperformed their relevant index, some less some more
My hypothesis before actually calculating these numbers was that LargeCap and MultiCap will be more or less same as the index while MidCap and SmallCap will outperform. But I was surprised to see that even LargeCap and MultiCap also outperformed their respective index.
- Median Returns for Equity MFs with AUM > Rs. 100 Cr in each category
- Used same index as SPIVA report
- Used 5 years returns
Above chart clearly show that in each category a median mutual fund has outperformed its index with significant margins. There is a clear trend in outperformance as well that LargeCap category which is relatively predictable generated least alpha of ~2% whereas SmallCap category which is highly dependent on stock selection generated the highest alpha of ~9.5%.
I actually tried to work with SPIVA report but as data was dated so didn’t get the conviction to use it. So, I pulled the data on all mutual fund, ETFs and index to generate the above analysis. Would love to hear your thoughts why this is happening in India.
3) Selecting the best mutual fund (active investing) is a myth
Every advisor or customer is trying to figure out best mutual funds. But if you look at any rating or any robo-advisory suggesting top mutual funds, their advice/rating rarely live up to the expectations. It’s not like there is an error in their analysis but it’s like predicting future.
Above table clearly show that ranks of the mutual fluctuate significantly every year and there is hardly any fund that has provided consistent returns. When you look at all equity funds also, the story is very similar, it suggests that there is no consistency. The main reason is that funds that play the riskiest have maximum volatility in rank as well which is expected.
I tried to do another analysis where I looked at returns of all mutuals relative to their category median and see how many times any mutual fund beat the category.
As predicted by Aswath Damodaran consistent winner are rare, so is the case in India also only 10% of the funds which consistently beat category median. Another thing that is completely true is that there is no one strategy or person who can make the killing every time. It works sometimes and rest of the times it is luck.
Why and What is in the future?
I am still not sure why active investing worked in India and might work in future as well. But at the same time, I believe passive investing need to radically change for it to fit the bill for India. Other than following obvious problem like:
- Not enough liquidity: This is a chicken and egg problem but need to solved as active investing is solving it very well
- More option: Very limited set of passive funds are available in Indian
- Lower Returns: Probably some strategy based ETF/index funds be able to do better
Now coming back to some non-obvious problem is distribution. Today, mutual funds are sold not bought and the only reason it’s being done is due to the commission that distributors get which is bleak in the case of passive investing. Also, the advisor model in India is very nascent again and reason is very similar that advisors are not getting paid.
- Distribution to be innovative: The first thing that needs to be changed is distribution and change need to be digital. If it becomes digital, it will be cheaper and that can possibly reduce charges and make passive investing viable.
- Tech over fund management: Today, fund management is treated like an art but I feel it will become a science with the help of tech. That will obviously reduce the cost but it is not only about cost. Technology can make it democratic. Anybody with a good idea and strategy will be able to create mutual funds and hire current mutual funds just for their services like a custodian, etc. Over time it will become like an open platform. This will boost competition and the best will win.
I am certain that this will not be solved by existing establishments but by fin-tech companies. Hoping that this happens sooner than later.