The rise of Passive Investing

Passive Investing is a strategy which involves exactly replicating the holdings of an index. The benefit of such a style is that it can be run at a large scale with a very small team, thus keeping costs very low. Further, the returns closely track the index, so there is no risk of underperforming the index by a wide margin; a risk that is always present in active management. Active Investing requires a team of talented and expensive fund managers who constantly analyze companies, industries and economic conditions with the aim of outperforming their benchmark index.

The idea of passive investing was introduced in the 1970s by John Bogle, the founder of passive investment giant Vanguard. He was motivated by the Efficient Market Hypothesis, according to which new information is always reflected in stock prices immediately, making it difficult for any fund manager to outperform the underlying index. In 1976, Vanguard launched the world’s first index mutual fund in the U.S. attempting to generate equivalent returns of the S&P 500 with low fund expenses.

‘Index funds’ and ‘Exchange Traded Funds (ETF)’ are the most common forms of passive investment vehicles. Index funds are similar to any mutual fund (basket of securities) tracking an index, while ETFs are securities that track an index closely and are traded on the stock exchange like any stock. 

Over the last several years as information flow has become faster, active fund managers have started to underperform their benchmarks across markets, leading to criticism of their high fees compared with passive funds. In the U.S., 70% of large-cap funds have underperformed their benchmark S&P 500 over a 3-year period, and over 83% have underperformed the S&P 500 over a 10-year period. 

Now the same trend seems to be playing out in India as well. As per a study by S&P in 2021, over 87% of actively managed Indian large cap funds have lagged the S&P BSE 100 index during 2018-2021.

Passive funds are growing fast in India, also helped by the inflows from the EPFO and NPS due to government initiatives. As of March 2021, 10% of the total assets under the mutual fund industry were invested in passive funds, up from 2% in 2016. Passive funds have an average expense ratio of less than 0.5% compared with 1.5% for large cap funds in India.

In spite of exactly replicating the holdings of the index, passive funds can never generate the same returns as the index since they incur operating expenses for running the fund, such as brokerage on the fund’s buy & sell transactions, salaries of the fund manager & technology costs. Also, they are not able to deploy 100% of the money invested with them due to the timing of inflows and redemptions. All these factors contribute to the difference in returns which is called tracking difference. In India, the best passive funds have a tracking difference of 0.3-0.5% annually.