-By A Nitheesha
India is undergoing a profound transformation in its investment landscape, driven by the exponential growth of passive investment vehicles like index funds and exchange-traded funds (ETFs). Folios of index funds are projected to double this year, while ETF folios have already witnessed a significant 37% growth. This has translated to phenomenal YoY growths of 23 percent for AUM for passively managed investments, peaking as high as ₹11 trillion in AUM within the first 11 months of the year. Such flows are not specific to India; instead, they come at a time when ETF industry net inflows experienced an unprecedented $1.4 trillion byOctober 2023, breaking a previous annual record. A larger and growing number of investors find the cost-efficient, transparent, and diversified nature of passive strategies most appealing. The introduction of innovative index-based products targeting high-growth sectors like electric vehicles, real estate, and modern automotive industries has further helped this trend in India. Not only do these products expose promising global themes, but they also help investors to diversify their portfolios based on emerging trends. Because these vehicles are becoming popular, they are democratizing access to capital markets. In doing so, investments become accessible to a much wider participant.
Key Drivers Behind the Shift
Several factors are driving the growth of passive investments in India. The cost efficiency is perhaps the most compelling reason behind this shift. Passive funds, because of their very low expense ratios, are far more economical than actively managed funds, which makes them extremely attractive to cost-conscious investors. Consistent benchmark indices performance also increased investor confidence and led to a departure from speculative trading towards stable long-term strategies. In this regard, the fund management companies made the most of this trend by providing products that could be directed to a range of types of investors such as retail investors, high-net-worth individuals, and family offices by launching sector-specific indices.
This trend of increased SIP investment in index funds shows that a disciplined approach is being practiced by investors. During the month of November 2023, SIP inflow into index funds alone were ₹1,246 cr, which was 5% of total SIP inflow. It is in this direction that individual investors are opting for structured investment strategies over a long time.
Capital Market Impact
This rapid adoption of passive investments has deep implications for capital markets in India. A high trading volume in ETFs significantly increases the market's liquidity, while the dependence on benchmarks has somewhat restricted the volatility caused due to speculatory activities, and thus resulted in a more stable financial structure. It creates confidence amongst institutional investors as well as among individual investors. But this is not without its challenges; the most apparent one is the fact that large-cap companies dominate the major indices and thus can potentially marginalize smaller firms, suppressing innovation and growth in less-represented sectors. This worry of a decline in active research and investment into emerging companies because of the ascendance of passive funds potentially threatens the long-term dynamism of the market.
Global and Local Momentum
Global momentum in passive investments continues to accelerate with ETFs ending 2023 with more than $15 trillion in total assets. The growth accelerates the convergence of the preferences of both retail and institutional investors towards low-cost and diversified investment vehicles. In parallel, innovation in the ETF space remains a stimulant for the development of new products, from thematic and alternative investments to private equity and digital assets. It is no different in India.The rising inflows into index funds point to the high demand for passive investment choices. On the other hand, active fund managers are facing mounting pressure as passive funds have been outperforming net inflows consistently. For example, in the U.S., equity index funds recorded inflows of $415.4 billion through October 2023, while actively managed funds registered outflows of $341.5 billion. This is being met with responses from fund houses in India, wherein new passive products are leading the pack and changing focus in the asset management world.
Challenges and Future Considerations
There are many virtues in being a passive investor, but the growing dominance of such an investment strategy has some serious drawbacks. Concentration of funds in a few large-cap companies distorts the dynamics of the market and creates inefficiencies in capital allocation. Such imbalance might reduce incentives for active research and investment in smaller firms, potentially stifling innovation and growth of emerging sectors.
Passive strategies pose an increased threat that could lead to higher market risks during recession periods. The reason behind this is that huge draws from
index-based funds create massive price volatilities in highly weighted companies. Regulators and market players need to address these issues towards providing an efficient and well-balanced financial system. Innovation in passive products as well as policies promoting diversification and inclusion in investment can reduce the risks posed by these products.
Looking Ahead: 2024 and Beyond
For India, 2024 is an inflection point in the investment landscape. Low-cost, transparent, and stable returns are probably going to be the moving forces of passive investments into the capital markets. Balancing a financial ecosystem where innovation is encouraged but is not at the cost of market stability should be considered as this momentum builds forward.The way forward is that all regulators, asset managers, and investors must act in a collective manner in response to the challenges arising from passive strategies. Sustainable growth of India's capital markets can be obtained with an inclusive and diverse range of investment opportunities that would bring benefits to all.The ascendency of passive investments could help shift not only how markets operate but also the way investors think and play in the financial ecosystem if adequate measures are in place.
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