However, recently index funds and ETFs have gained significant AUM in India, due to entry of PFs into equity market
Index Funds and Exchange Traded Funds (ETFs) are based on a school of investing called ‘passive investing’. Passive investment is an investing strategy that tracks a pre-defined popular or broad-based market index. Passive funds are designed such that they replicate this existing index in entirety rather than taking a view on the suitability of individual stocks within the index.
On the other hand ‘active investing’ involves conscious stock selection with an objective of generating superior returns to an index or benchmark (also known as alpha). The biggest difference between the two is that here is that active managers carry out research and take a view on the stocks that they include in their portfolio and thus there is a future expectation based on which the fund is created.
Passive investing strategies are an inherent bet on the markets being ‘efficient’. Efficient markets essentially believe that the prices of securities already factor in or discount all available information. On the other hand, in an ‘inefficient’ market, market forces sometimes drive asset prices above or below their true value. Hence some securities will be overpriced and others will be underpriced, which means active managers can take advantage of the mispricing to outperform the market.
Apart from market efficiency, another differentiator between the two categories is their fees. Active funds typically charge higher fees compared to passive index funds. As long as the expected out-performance can justify this higher fees, this is fine. However the challenge comes if the fees is either too high or the expected outperformance too low.
Over the years, Index and ETFs have been very popular in markets such as the US where market mispricing tends to be low relative to fund manager fees and trading costs. In India however, given the high level of out-performance generated by fund managers active funds were the preferred choice of investors.
However, in the last couple of years index funds and ETFs have gained significant AUM in India as well. This has happened as a result of the entry of provident funds into the equity market. PFs have preferred allocating to ETFs over active funds in the initial phase maybe driven by the simplicity of these structures and since this is their first step into equity as an asset class. We expect that over time as they mature, PFs will start evaluating active managers as well. Retail investors have continued to prefer active funds over this time. Eventually as the market grows, there will be space for both structures.
The writer is head-products and fund manager, Axis Mutual Fund
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