With the Indian mutual fund industry dynamics steadily transforming, the active vs passive investing debate has seen a renewed vigour. If you study the numbers, you will find a recent reduction in alpha for active mutual funds and, almost parallelly, a sharp surge in the AUM of passive mutual funds, making the debate intriguing. Globally, it has been often seen that in the lesser mature mutual fund investing markets like India, the active fund management style plays out more than passive. But as the market develops, inevitably, the passive style of investing becomes increasingly prominent. The numbers support this theory as well. While in 2010, only 14% of the assets of open-ended mutual funds worldwide were constituted by passive funds, in 2020, it grew to 31%. In India too, the share of passive funds has seen an exponential rise in the last 5 years, although over a much lower base. So, does that mean passive funds have become the more preferred option now? Let us find out.

The impressive upward trajectory of passive mutual funds

I think it is not really fair to position active funds over passive or vice versa purely because they represent entirely different fund management strategies. If anything, the emergence of passive funds is a sign of a maturing investment market in India. Take the case of large-cap stocks, for example. With a rise in structural/regulatory changes like tighter investment mandates and scrutiny around benchmarks, we have increasingly seen the alpha of large-cap funds dipping (although not for all). So, for this category, passive becomes a relevant choice since your aim then is to save cost and ride on the beta, in case the alpha generated isn’t justifying the expenses you are paying. Bear in mind though, that not all large-cap funds are suffering from an alpha-lag. For example, in FY20, almost 20% of the large-cap funds did outperform the index. Hence, this decision will require some discretion and can’t be a universal rule for all actively managed large-cap funds. Having said that, small and mid-cap segments, in contrast, are relatively less mature and still have a lot of scope for active strategies.

Similarly, for fixed income funds, India has seen a growth of passive funds for various reasons. Cost definitely being one, as fixed-income funds are not inexpensive when it comes to active duration and credit strategies. Apart from the cost, the transparency and diversity in portfolio construct also adds to the need for fixed income ETF product innovations. The other prominent factor is the choice of options. India has a lot of fixed income indices across different segments, and it shall be fair to say that we have not really seen a lot of actively managed funds getting their duration or credit calls consistently right, making the index a very significant option.

All these factors and many more have contributed to the rise of passive mutual fund investments. Will passive investments see more inclusion in the coming years? Sure. Will they take the place of active mutual funds? No, let me explain why.