Rise of Passive Funds: Institutions Have a Bigger Role to Play in the Rising AUM of Passive Funds

Lately, passively managed schemes have rallied up and this shows that passive funds are performing better than active funds. Passive Funds are gaining wider attention for their uncomplicated way of investing which mirrors the performance of a specific index whereas, on the other hand, active funds have become complicated to manage because of the constant unpredictable moments in the market and have a higher expense ratio as it involves a fund manager who is managing your assets. On the contrary, passive funds have lower expense ratios because the fund manager's role is limited, and the investment strategy is relatively straightforward.

Passive funds, commonly known as index funds or exchange-traded funds (ETFs), have garnered immense popularity among investors of all stripes, from individual retail investors to towering institutional entities. The passive funds seem to believe in more accumulation of wealth in the long term rather than beating the market, unlike active funds.

According to Morningstar, Passive funds have witnessed 100% growth in terms of the number of funds alone in 2022 The total AUM in Index funds stood at Rs 1,28,984.39 Cr in December 2022, with inflows into index funds totalling about Rs 85,173.43 Cr during the year.

Amidst the rise of passive funds, exchange-traded Funds (ETFs) have emerged as a cornerstone of institutional investment strategies. Big institutions in India, including pension funds, insurance companies, and government entities, are actively contributing to the growth of ETFs (Exchange-Traded Funds). The AUM of ETF schemes (excluding gold ETFs) surged to Rs 6.44 trillion as of February 29, 2024, from Rs 2.73 trillion three years ago, according to data released by the Association of Mutual Funds in India.

According to various annual and quarterly reports, these institutions have made substantial allocations to ETFs as part of their investment strategies. For instance, SBI's pension and gratuity funds allocated 11.61% and 10.67%, respectively, of their plan assets to ETFs. LIC significantly diversified its investment portfolio by allocating a substantial portion to the ETFs of 24.01%. HDFC and EPF also demonstrated their commitment to ETFs by holding significant positions in prominent ETFs such as SBI Nifty 50 ETF and S&P BSE Sensex ETF. HDFC's holdings represented 1.47% and 0.99% of the capital, respectively, while EPFO allocated Rs. 1,96,688 Crores to ETFs, constituting 9.21% of its total assets. Moreover, the ETF market has experienced remarkable growth, with the AUM skyrocketing from around Rs 12,000 crore at launch in 2019 to over Rs 50,000 crore presently, as stated by DIPAM. Overall, these figures underscore the increasing importance of ETFs as preferred investment vehicles among big institutions in India, driven by their benefits of diversification, liquidity, and cost efficiency.

Now we know that big institutions play a pivotal role in the rising AUM of passive funds, but why are institutional giants investing heavily in this segment?

Strategic Allocation: Passive funds help big institutions like pension funds, insurance, and endowments for strategic allocation of their funds as they are less risky, offer diverse portfolios, and help them comply with the strategy goals of big institutions.

Transparency and Accountability: Passive funds are transparent as they replicate certain underlying indices in the market, disclosing their holdings and investment objectives to investors. This transparency adds up to the passive funds being accountable for every penny that might go up or down, as their performance is directly tied to the performance of the underlying index.

Cost Considerations: Cost efficiency is paramount for big institutions managing large pools of capital. Passive funds typically boast lower management fees compared to actively managed funds, translating to substantial cost savings over time. Institutions, cognizant of the impact of fees on long-term returns, are increasingly drawn to the cost-effective nature of passive investing.

Liquidity and Scalability: Passive funds, particularly ETFs, offer high liquidity and scalability, enabling institutions to execute large trades efficiently without disrupting market dynamics. This liquidity and flexibility make passive funds an appealing choice for institutions managing sizable portfolios.

Long-Term Investment Horizons: Many big institutions have long-term investment horizons, spanning decades or even generations. Passive funds, with their buy-and-hold approach and low turnover, are well-suited to the patient capital requirements of institutional investors. By adopting a long-term perspective, institutions can harness the power of compounding and ride out short-term market fluctuations.

Regulatory Compliance: Institutional investors are subject to regulatory requirements governing their investment activities. Passive funds often offer regulatory compliance advantages, such as adherence to investment guidelines and restrictions. Institutions may allocate capital to passive funds to ensure compliance with regulatory frameworks while optimizing investment outcomes.

As big institutions dive into passive investing, it's shaking up the investment world. This shift affects asset managers, financial markets, and even the rules that govern investing. It shows how passive investing is gaining power and reshaping the traditional ways of investing.

However, the ascent of passive funds also raises pertinent questions regarding market efficiency, corporate governance, and the role of active management in price discovery. Critics argue that the propagation of passive investing could lead to market distortions and diminished capital allocation efficiency over time. Nevertheless, proponents contend that passive investing democratizes access to diversified investment opportunities and fosters greater transparency and accountability.

In conclusion, the rise of passive funds represents a significant paradigm shift in the investment landscape, with institutions playing a central role in driving their exponential growth. As institutions continue to embrace passive investing strategies, the impact on financial markets and investment practices will likely be far-reaching. It is essential for investors, regulators, and industry participants to closely monitor these developments and adapt their strategies accordingly in the ever-evolving world of finance.