Are Indian Investors ready to choose Index mutual funds or ETFs?

You may have noticed an increased interest in passive mutual funds (index funds or ETFs). Is this for real? Are Indian Investors ready to choose Index mutual funds or ETFs? Here are some facts.

Published: February 21, 2020 at 11:03 am

Last Updated on December 29, 2021 at 5:22 pm

Zerodha CEO’s announcement that it has filed for an AMC license has been hailed as both a “welcome” and “disruptive” move by netizens. The brokerage house wishes to focus on passive funds with the possible involvement of quant models reports the Business Standard. Already the expectation from them seems to be “low cost” (direct?)  index funds and/or ETFs. While it remains to be seen how their AUM grows (the only way for an AMC to stay alive), it is also important to ask if Indian Investors are ready for low-cost index funds. Here is why I think we are a long way away from low-cost passive investing making a dent in the existing setup.

The following arguments were keyed-in prior to the above announcement. This article is meant to highlight some facts associated with passive investing and how Indian investors are a long way away from embracing these products. It is not a commentary of Zerodha’s future. Since nothing is known about their style of operation and it makes little sense to comment about it now.

Did you know that you could currently choose among a 2-star rated Nifty Index fund, 3-star rated Nifty Index fund or a 4-star rated Nifty index fund (star rating by Value Research as on Feb 2020)? The same applies to Sensex: one can choose from 3,4 and 5 star rated index funds! So much variation in returns from funds with identical  portfolios!

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As you may have guessed, the high-rated funds are those with low expenses and “high AUM” Read moreThese five index funds beat their indices! Why you should avoid them!

If you dig into AMFI AUM data, you will find surprising data such as The regular plan of UTI Nifty Next 50 Index Fund accounts for 47% of its AUM (last quarter of 2019). Why on Earth would an investor wanting to track an index choose the regular plan where commissions affect returns? This is the sorry state of affairs in India.

Of course, it is not true for every index fund (UTI Nifty Index regular plan accounts for 21% of AUM, last quarter of 2019), but distributors play a key role especially in the NFO stage where a big initial inflow is necessary to justify the launch (which comes with significant promotional costs – paid tweets, articles, videos etc.)

The ETF universe is even worse. With no regular plan and no commissions, most ETFs have a handful of crores with a huge deviation between price and NAV. Read more:

The featured image above has been reproduced for convenience. It shows the AUM growth (blue) and the NAV movement of ICICI Nifty Next 50 Direct Plan. Notice that the AUM zoomed up months after the NAV moved up. Then the AUM slowed when the NAV has been underwater for more than two years (less than its Max in Jan 2018) and in Jan 2020 registered a sharp fall.

NAV movement of ICICI Pru Nifty Next 50 Index Fund Direct Plan along with its AUM
NAV movement of ICICI Pru Nifty Next 50 Index Fund Direct Plan along with its AUM

The lab between the AUM and NAV is also known as the behavior gap. Or why investors’ returns are not the same (lower) than the instrument returns. The AUM zoomed when the fund was rated 5-star by Value Research. It is now 2-star rated (amusingly the regular plan is 3-star rated). Most investors tend to put money after they see a good performance and pull out when they see a bad performance (when they should be doing the opposites at least for long term goals).

In other words, past performance and peer performance are the key drivers of AUM. Index investing can never pick up unless and until investors see active funds underperform consistently at a casual glance (last 1,3,5 returns). At the moment one will have to dig deeper, look at rolling returns to recognize active funds struggled even before the SEBI categorization rules.  Read more: (1) Only Five Large Cap funds have comfortably beat Nifty 100! (2) This will change the way you invest: S&P Index Versus Active Funds report

If you head over to Value Research and sort large cap funds in terms of decreasing last one year returns, you would find that the first index fund in the 25th place out of 58 (counting both regular and direct plans)! Meaning 24 active funds have reacted well to the divergence between the top half of Nifty/Sensex and the rest of the market.

This does not mean active investing is “back with a bang”, but it would certainly seem so to the casual observer and most investors are nothing more than that. All this talk about SEBI increasing the large cap universe beyond the top 100 does not help either.

Notice that more and more social media chatter about index investing occurred at a time when only a few stocks of Nifty and Sensex moved up while the rest of the market languished.  Read more: Return difference of Nifty 50 vs Nifty 50 Equal-weight index at an all-time high!

Increased interest in passive investing when the going is good is unlikely to last long. If the index AUM grows reasonably during prolonged periods of no returns, then we can take the Indian passive investor seriously.

Also, most mutual fund investors believe in the “masala mix” approach. They buy a little bit of everything that is good. If US stocks do well, buy a feeder fund. If Nifty Next 50 does well, get that, if Nifty/Sensex do well, get that, but do not sell existing holdings! Most mutual fund portfolios have more funds than the digits in its XIRR. So it is irrelevant if such portfolios contain “some exposure” to index funds or not.

For now, there is no evidence that suggests that passive investing will make a difference in the near future other than some tweets here and there. It is folly (social media bias?) to extrapolate that to the entire mutual fund market, especially Millenials who love their small cap funds (as long as they see profit).

As for Zerodha, there is plenty of space for another player to get a slice of the AUM without stepping on anyone. It is premature to assume that they would be successful (or unsuccessful) let alone trump the big wigs. All the “big AMCs” have banks to shove funds down lazy customer throats. Wonder if Zerodha should have applied for a banking license first!

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