While passive funds have reached a fairly mature stage in developed countries like the USA, they are still at a nascent stage in India. That said, India is playing catch up and has experienced an exponential growth of assets in the last few years. As of March 2020, with more than 110 passive funds (across ETFs and Index Funds) and AUM crossing Rs 2 lakh crores, the growth in passives has been encouraging. Our very own BHARAT Bond ETF program has now crossed Rs 25,000-crore AUM.
Globally, the passive category has evolved over the years, moving from plain vanilla market cap based to funds specific to geographies, market segments, multi-factor funds and theme-based funds like technology, healthcare, consumption, etc. In India, however, passive investing is largely limited to market cap based factors with a small number of passives based on other factors like quality and volatility.
In fact, passive funds are largely seen as an alternative to traditional large cap funds, explaining the growth of NIFTY-based index funds and ETFs. As investors evolve, however, they should look beyond passives in other categories – specifically, passive thematic index funds as an alternative to actively-managed thematic funds.
The industry today has over 80-actively managed thematic/sectoral funds with an AUM of over Rs 54,000 crore as on Aug 2020. This marks decent growth from Rs 37,000 crore of AUM three years ago. We believe that there is a strong case to go passive while investing in thematic/sector funds for multiple reasons.
Firstly, active thematic funds have underperformed their respective benchmarks in the medium to long run. In some categories like banking & financials the underperformance is severe. On a three-year average rolling returns basis, actually, most of the funds have underperformed the benchmark. This may not be surprising given the small universe from which the fund managers have to generate alpha and a large number of companies falling into an increasingly well-researched large cap universe. Such funds, to generate alpha in a small universe, also have very concentrated portfolios with an average of 20-25 stocks, only increasing the risk in such funds.
Moreover, thematic Index funds can be a low cost way to participate in some promising themes like healthcare, consumption, and financial services which have structural tailwinds in the long run. A passive construct makes them true to label with 100% exposure to stated theme/sector unlike active thematic funds where 20% can be invested outside the theme as per SEBI guidelines, a provision active funds do use.
Finally, some thematic funds also take global exposure which needs deep research and expertise. This is tough for most MFs, who don’t have physical presence outside India and a dedicated research team for such research. Indexing solves this problem by simply investing in stocks that are part of the index basis predetermined criteria. It makes the market be the fund manager for such exposure.
We do believe, investing in a theme itself is a very active asset allocation call, which can be achieved by investing in a simple thematic index fund, where active investing has had a mixed experience. One important question is who should invest in such thematic index funds? This is a category meant for investors looking for long-term strategic allocation to structurally strong themes. Moreover, investors looking for tactical allocation to capture mean reversions in performance – like bounce back after long-term underperformance in a sector – can look at this category.
Today, let’s take healthcare as the example. The theme has seen underperformance in the last five years and has the potential to generate reasonably good performance in coming years and the mean reversion has already been visible. Valuations are reasonable and growth opportunity in the sector is attractive in the long run given structural tailwinds like rising healthcare awareness, rising lifestyle disease and introduction of newer treatments to treat such ailments, amongst few. A healthcare index fund would be ideal in such a scenario which can provide low cost, undiluted exposure to healthcare themes. It could also capture global exposure missing in active funds, but important in a theme like healthcare, where markets like the US drive a lot of research / spends.
Of course, thematic funds have inherent risks, whether active or passive. They are not as correlated to broader markets, which means performance can diverge. Performance can be cyclical, with lulls of low returns. Investors either need to time the entry and exit intelligently, or have long-term strategic allocations where they can patiently ride out a cycle or volatility.
As the passive journey continues to evolve, thematic index funds can add another interesting dimension to this growth story and be another useful solution in investor portfolios.
(Radhika Gupta is the MD & CEO of Edelweiss Asset Management Limited)