Wealth Management

Active Vs Passive Investing – Will India Ape the West?

April 2022

Read Time: 8 minutes

In the annual shareholder meeting of Berkshire Hathaway, market veteran Mr. Warren Buffet advised investors to bet on index funds. He further added that he had instructed his trustee, who oversees his estate, to invest 90% of his wealth into index funds for his widow. According to him, the “best thing” for investors was the S&P 500 Index.

Mr. Buffet has advocated his belief in the index in the past too. In 2008, he challenged the hedge fund industry that in a 10-year period the S&P 500 would outperform any portfolio of hedge funds. Protégé Partners LLC was the only company to step up and accept the challenge. They handpicked 5 hedge funds (names of which have not been disclosed publicly) and a $ 1 million bet was in place. The challenge was to beat an Index Fund tracking S&P 500, selected by Mr. Buffet. 9 years down the line, Protégé had to concede defeat with average return on the selected five funds at 22%, compared to a whopping 85% delivered by the S&P 500 Index Fund.

(Source: https://www.investopedia.com/articles/investing/030916/buffetts-bet-hedge-funds-year-eight-brka-brkb.asp)

There’s a great argument for Index Funds

The active vs passive debate has been around for some time now. Clearly, the American market has some leads for us. The United States has over 1675 index with an AUM of over $5 Tn. It is also the only stock market that provides such a wide range of ETFs - from tracking major US stock indices like S&P 500 & NASDAQ 100, to providing geographical diversification by investing in emerging markets, developed markets, Asia Pacific, Far east, Europe, China, Australia etc. Moreover, there are also ETFs focused on various sectors like financial services, healthcare, consumer; ETFs focused on themes like value bias, dividend yield, innovation led companies, green energy etc.

The rise of passive investing is reflected in the large size of Assets Under Management (AUM). To put things into perspective, top 5 ETFs have a cumulative AUM of ~$ 1.54 Tn, with expense ranging between just 3 to 20 basis points per annum! This means if one invests a million dollars, they end up paying only USD 300 per annum as fund expenses.

(Source: Bloomberg)

The shift from actively managed funds to passive ETFs is also justified in the performance. For example, the largest ETF tracking the very popular NASDAQ 100 Index is Invesco QQQ Trust with an AUM of almost $200Bn. It has delivered a 10-year CAGR return of 19.43% as on March 28th, 2022. During the same period, actively managed funds aimed at beating the NASDAQ 100 Index, have delivered an average return of ~15.57% - an underperformance of almost 4%!

Further, these funds have an average expense ratio of 1.34% whereas the ETF operates at a much lower cost of just 20 basis points!! To add to this, the fate of most other actively managed funds has not been any better compared to broad market indices like the S&P 500 & NASDAQ 100.

(Source: Bloomberg)

Let’s look at what the SPIVA Scorecard tells us. The SPIVA scorecard is published by S&P DJI and compares actively managed funds against appropriate benchmarks. Exhibit 1 below provides a snapshot of the data published by their scorecard as of 31st December 2021:

Exhibit 1: Percentage of Large Cap funds that underperformed S&P 500 across various time horizons

Source: SPIVA website, as of December 2021.

The “Persistence” angle adds to the debate

The problem of persistence is another area of concern. The SPIVA Persistence Scorecard shows that regardless of asset class or style focus, active management outperformance is typically short-lived, with few funds consistently outranking their peers. The mid-year report dated October 2021 showed that out of the top quartile funds in June 2019, very few managed to maintain the momentum and remain in the top quartile, 2 years hence (refer exhibit 2).

Exhibit 2: % of funds that remained in top quartile 1 year and 2 years down the line

Source: SPIVA website- U.S. Persistence Scorecard Mid-Year 2021 (October 25th, 2021)

How to read?

Refer the first two bars on “All Domestic Funds”. Of all the top-quartile domestic US funds as on Jun-19, 53.6% of the funds remained in top quartile by Jun-20 and only 4.8% remained in top quartile by Jun-21.

More alarming is that many of these could not even deliver the positive alpha (refer exhibit 3). The question arising in investors’ minds therefore is - “Will I be able to select a fund that remains in the top quartile & generates alpha consistently year on year?”

Exhibit 3: % of funds that continued to generate a positive alpha 1 year and 2 years down the line

Source: SPIVA website- U.S. Persistence Scorecard Mid-Year 2021 (October 2021)

How to read?

Refer the first two bars on “All Domestic Funds”. Of all the domestic US funds that generated a positive alpha as on Jun-19, 63.4% of the funds repeated the alpha generation in 12-months ending Jun-20 and only 24.7% managed the same feat in 12-months ending Jun-21.

What all of this means

The above data shows that American stock market is now a very evolved, very mature stock market. Exposure to such a market is best taken through ETFs. With access to a wide range of themes, sectors, geographies, market capitalizations, investors are spoilt for choice. Of course, the economical pricing is the cherry on the cake and should not be underestimated!

India becomes active on “passive” investing

It is no wonder then that we see a buzz around passive investing back at home too. The rising popularity is clearly broad based given the surge in AUMs (refer Exhibit 4). Across asset classes, investors have started allocating money to ETFs, Fund of Funds & Index funds in a much more meaningful way.

  • Overall, the passive fund AUM has seen an increase of 4x between Jan-2019 and Feb-2022.
  • Indian investors have taken exposure to international equities in a significant way, the growth multiple in this category is over 100x in the same period. 
  • Apart from equity, Debt too has emerged as a popular asset class for passive funds with a growth multiple of over 39x in the same period.

Exhibit 4: Year on Year Assets under management (AUM) for ETF + Index Funds:

Source: ICRA Online Ltd. Data as on 28th February 2022. Amounts in INR Cr.

The growing acceptance for passive funds is also validated in the slew of new fund offers (NFOs) of ETFs by AMCs over the last 2 years. The total number of ETFs launched in 2021 & 2022 (so far) across Debt, Equity, Gold & Silver asset classes is 89, and cumulatively they garnered an AUM of over INR 40,000 Cr!

This dramatic increase in asset size suggests a keen shift to passive funds, especially in the large cap space. Of the INR 353,353 Cr in domestic equity ETFs, over 52% is in Nifty 50 & another 25% in Sensex ETFs (cumulatively INR 274,963 Cr).

Compared to this, total (AUM) across the mutual fund industry in actively managed large-cap schemes is INR 218,565 Cr as on 28th February 2022 (Source: ICRA Online Ltd). The size of Nifty/Sensex ETFs has become larger than that of actively managed large cap funds (refer Exhibit 5)

Exhibit 5: AUMs of Nifty/Sensex ETFs have seen a steady growth over last 3 years and even surpassed AUMs of actively managed large cap funds in last two years.

Source: ICRA Online Ltd. Data as on 28th February 2022. Amounts in INR Cr.

What has prompted this shift?

The increase in AUM sped up dramatically after 2018, i.e., in the last 4 years. 2018 was a challenging year for stock markets with only a few stocks driving the index up and almost all actively managed funds failed to deliver a positive alpha. In fact, the underperformance to benchmark was quite severe in this year across all categories, but specifically in the large cap category (refer exhibit 6).

Exhibit 6: Performance of Nifty 50 TRI vs Large Cap Funds

Source: ICRA Online Ltd. Data as on 28th February 2022.

So far in the first two months of 2022, only 4 funds have outperformed Nifty 50 TRI forming just 28% of the total large cap AUM. In fact, if we see the trend for last 3 years, 2021 was the only decent year for the large cap universe where a majority of them outperformed. (refer Exhibit 7).

Exhibit 7: % of Large-Cap AUM that outperformed Nifty 50 TRI

Source: ICRA Online Ltd. CY 2022 Data as on 28th February 2022.

Concluding Thoughts

This shift from actively managed funds to ETFs in the large-cap space indicates the awareness among investors that alpha generation is not so easy. In fact, with the increase in regulations on the MF industry and reducing active share in large-cap schemes, alpha generation has become a challenge.

It is therefore safe to assume that going forward, ETFs will feature as a significant part of Indian equity portfolios specifically in the large-cap space, where investors target to capture the Beta of the market. The small and mid-cap space still carries many inefficiencies and active management could deliver handsomely in this space.


Author: Twisha Shah, AVP – Investment Solutions Group, Avendus Wealth Management & Shravan Sreenivasula, Executive Director -Investment Solutions Group, Avendus Wealth Management

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