Active vs Passive Investing: US and India

In Developed markets such as the US, there is an ongoing shift from actively managed mutual funds to passive funds such as Exchange Traded Funds(ETFs). It’s no secret that capital inflows to passive funds are on the rise as actively managed funds in the aggregate are contracting. Based on Morningstar data, around $1.3 trillion has been flowing into passive Investment vehicles over the past three years, while a quarter of a trillion dollars ($250 billion) was leaving actively managed funds at that same time. Another interesting twist in the tale is that a lot of these ETFs get their heaviest use from some pretty active traders and are not just the choice for passive Investors.

Before delving further, let us first understand what active and passive Investing is all about. A passive management strategy assumes that the market's expectations are essentially correct or, more precisely that Investors cannot add value (net of expenses of analysis & trading) by second guessing these expectations. Under a passive strategy, the manager does not have to make independent forecasts, and portfolio should closely track an Index. An active management strategy essentially relies on the manager's forecasting ability. Active managers believe that they possess superior skills that can be used to exploit opportunities in the market.

Exchange-traded funds, as the name implies, trade on an exchange like any other stock. Most track an index, eliminating the need for a traditional portfolio manager, which makes the funds cheaper than actively managed mutual funds. Some ETFs, like the SPDR S&P 500, own a broad basket of stocks mimicking market capitalization-weighted benchmark Indexes. Other ETFs are narrower and more esoteric, tracking Smart beta Indexes or factor Indexes where equities basket is created based on the factors such as momentum, volatility, or dividend yield. While in MSCI, I had an opportunity to develop a number of factors and smart beta Indexes working with Quant researchers on which several ETFs are launched. Such ETFs are blurring the lines between Active and Passive investing.

The rise in ETFs in US is being driven by shifting consumer preferences for passive investments given their lower cost. Active Mutual Funds have high expense ratios in the range of 2 to 3 percent whereas ETFs have less than 1 percent expense ratio. Moreover, active Fund managers are not able to justify their high investment cost because of shrinking alphas. This is happening as active managers get better, markets get more efficient, and then there’s actually less alpha on the table to go around. Also, technology coupled with Fiduciary push for transparency along with democratic access to information on the Internet for doing real cost and performance analysis has made sure that advisers cannot sell active mutual funds for commissions. So investors best interests are taken into account to provide best investment choices to justify the advisory fee and ETFs fits the bill for advisers who is trying to reduce active fund manager costs. Also, online brokerage platforms have reduced the distribution costs and Investors are more keen on buying no-loads funds such as ETFs providing better returns compare to actively managed funds. Lately, the ETF model is also getting heavily commoditized among the big players and there is a race to almost zero expense fee in ETFs as well. Robo-advisory is also commoditizing the advisory model providing a very low-cost advisory services to get the optimal investment choices. “Active isn’t dying—it’s migrating,” said Ben Johnson, director of global ETF research at Morningstar Inc. “It’s gone from being Coke versus Pepsi to big asset allocation decisions that use passive building blocks.”

Now coming back to India, things are drastically different here. Active Investing still has a potential to generate consistent alphas outperforming major benchmarks. In this regard, there have been considerable capital inflows in active Mutual Funds , but still, we have a long way to go here. A lot of new age advisers have come up to identify the right active Mutual Funds for Investors but still, Investors lack awareness about the implicit commissions involved in such Investments and how moving from commission-based advisers to fee-based advisers is a wiser choice to get the best active Investment products.

Also, ETFs are in a very nascent stage here. There are about 6,000 ETFs worldwide, according to research firm ETFGI LLP out of which only 39 ETFs are listed on Indian exchanges. Primary reason is that there are very limited underlying Indexes in Indian markets on which ETFs can be built. Of the NSE-listed ETFs, over one-third of them are gold ETFs. The Nifty 50 index is the next most popular with 9 ETFs based on it. The handful left is spread across banks, public sector enterprises, liquid bonds, and some thematic indices.The NSE and BSE do have indices along strategic and sector lines such as dividend, manufacturing, consumption, volatility, and so on but they are relatively new and there are a couple of ETFs on such indexes and are highly illiquid. So the another major deterring factor for ETFs in India is that there are not many liquidity providers(market makers) for the ETFs. Moreover, the regulator needs to push for a more robust institutional framework to bring in more ETFs in Indian markets and provide market makers the support to drive ETFs liquidity. Also, there is a lot of inefficiency in Indian markets which is exploited really well by Active fund managers who outperform benchmarks consistently and as a result active Investing still has a lot of prominence in India and pure market capitalization-weighted based Index ETFs cannot substitute that.

In such a scenario, what is the best possible choice for the Investors? One is to make right choices if they invest in active Mutual Funds and understand that they are paying 2 to 3 percent annually on their investments implicitly. Other is to follow advisers who are incentivised to select the best active investment choices for the Investors and don't push for more commission focused active Investment products. Also, technology can play a very pivotal role to provide all such investment cost and performance analysis while choosing right advisers and making fee-based advisory available at a very low cost where advisers can build the appropriate funds by doing active stock selections or select the right Mutual funds in their portfolios and Investors can allocate capital to such Advisers based on their risk-return profile objectives. Till we reach a point in future where we have a low cost matured passive Investment products for different risk-return objectives and themes, the systematic Indexed Investment model needs to be made available to the advisers technologically so that the active and the passive Investment amalgamation can be offered to Investors for long term wealth creation with complete transparency and at a low cost.