Passive investing styles have been gaining traction in developed markets and increasing in popularity in India. Anil Ghelani, Head of Passive Investments & Products at DSP Mutual Fund, shares his views on whether ETFs, index funds and smart beta strategies will eclipse active fund management.
Do you believe active fund managers are struggling to generate alpha?
It is only in the large-cap space that fund managers are finding it a challenge.
The first challenge has come from the strict categorisation of schemes.
Secondly, technology has changed the way we work. Now we have social media. Consumers are sharing feedback about products and services on social media. Earlier, when companies announced results, analysts would come share the report with fund managers the next day. Then the fund manager would read and process that information. Today, you get real-time information about anything. You will get 8 to 10 reports on earnings the day the results are announced. The information flow is faster. These trends are making it difficult to generate alpha in large-cap space.
In that case, what is the lure of passive funds, from an investor point of view?
Lack of alpha is not the only reason for the growth of passive funds.
Passive funds are easy to understand for average investors as they can be directly compared with the benchmark returns. For such investors, index funds can be a good starting point for investing in equities.
Low costs, transparency and ease of understanding will pave the way for the growth of passive funds in India.
If investors feel that active funds are not able to generate alpha even after paying a high total expense ratio, or TER, they could gradually move towards passive funds, just as we have seen in the U.S.
Talking about TER, are passive funds a viable option from the point of view of the profitability of an AMC?
There is a fierce race among some AMCs who have dropped costs, or TER, to unreasonable levels. TERs have to be competitive and win-win for all otherwise the fund house would end up spending rather than earning anything from such funds.
The fund TERs should ideally go down once the fund reaches a certain size. Even in the U.S. market, TERs of passive funds came down after they reached a certain scale. I recall that in 2014 BlackRock had an Exchange Traded Fund, or ETF, on S&P 500 which saw TER reduction from 12bps to 7bps after it reached a size of about $65 billion.
In India, we saw 7bps for Nifty 50 ETFs which were yet just starting to grow.
Within the fund house, do you find any ethical issues when it comes to flows in passive funds, that active fund managers can exploit?
In case the active and passive fund teams are common, and the same dealer is executing trades, that could come up. For example, let us say that Rs 100 crore comes to a passive fund. The dealer usually buys towards the closing of market. It could be argued that the active managers have bought some stocks in advance since they were privy about this inflow into the passive fund. This is unethical and not in the interest of investors.
At DSP, we approached passive investing with a long-term approach from a viability perspective. We want to be thought leaders in this space.
We invested heavily in people, processes and systems for building our passive team. We have a dedicated passive investing team and a separate dealing room. The active and passive management teams are not the same.
As the passive fund category grows and large investors conduct due diligence, such segregation of teams will be expected.
In recent months, besides the institutional demand in ETFs, even index funds have been getting good flows. For instance, in March 2020, large-cap as a category got net inflows of Rs 2,060 crore, while index funds got slightly higher net flows at Rs 2,100 crore.
Bear in mind that the large-cap category is about Rs 1.2 lakh crore, while the index funds is a much, much smaller Rs 8,000 crore.
But in comparison to active, there is not much complexity in managing passive funds.
In active funds there is ongoing research, forecasting company level metrics and making investment decisions which have an element of human bias built-in.
Passive funds are managed without human bias. At the time of setting up that formula or rule, a lot of fundamental research and analysis is done. Once it is up and running, there is no ongoing research and no human bias involved.
However, managing passive funds has its own unique requirements and challenges. The need to maintain a low tracking error. Manage flows by providing a smooth entry and exit to investors. If anticipating a big inflow, we can’t rely on a single basket order through one broker because not all stocks have enough liquidity and certain stocks have circuit filters. So we have to strategize the execution of the trades keeping various factors in mind.
One of the key aspects is dealing with corporate actions. A good example was the recent rights issue of Reliance Industries Ltd. It was a relatively complex issue since it was partly paid-up rights and these were not to be forming part of the index.
With the stewardship code, even passive funds in India have to actively monitor and engage with companies held across our portfolios. Participate in company voting. Track financial fundamentals. Analyse qualitative aspects – the ESG factors; environment, social and governance.
What about smart beta strategies for the Indian market?
Passive funds on smart beta indices or "factor investing” can be considered when an investor wants some active element in a passive structure, at a relatively low cost.
Factors are to assets what nutrients are to food – both milk and meat contain fat and protein – just as economic risk is present in equities, bonds and commodities. So, while healthy eaters look through the food they eat to identify the nutrients they contain, factors allow us to cut across asset classes and identify the true sources of risk and return.
Often, having a single factor product, such as momentum or quality or value can make the portfolio underperform at points of inflection when that particular factor does not do well due to changes in the underlying market. So multi-factor funds, such as a mix of quality, growth and value could have a better potential to perform across market cycles.
Such funds are more likely to be structured in index fund format and not so much in an ETF structure. The main reason for this is secondary market liquidity in ETFs. For a market maker hedging of open positions becomes difficult in ETFs for smart beta products leading to wider spreads and often lower liquidity on the exchange.
Smart beta products are currently being embraced by high net worth and institutional investors who understand these products. It will take some time for smart beta products to pick pace in India.
You mention secondary market liquidity. How can the industry overcome the issue of illiquidity in ETFs?
One of the important parts of the ETF ecosystem are market makers who provide 2-way quotes on the exchange and ensure liquidity.
To ensure ETFs have liquidity on the stock exchange, AMCs have authorized participants/market makers giving 2-way quotes on the exchanges.
Globally, there are specialised entities operating as market makers. As of now none of these players are operational in the Indian market.
In many global markets, there is a separate registration required for market makers who are tasked with providing liquidity for the ETFs. These registered market makers get special benefits. To avail these benefits, they have to abide by the guidelines of market-making in terms of liquidity, spreads and volumes.
In India, currently, there is no separate registration or regulation for market makers.
This is one factor which could motivate more market makers to become active and increase the overall participation.
