While actively managed equity funds continue to accumulate flows in India, the local mutual fund industry is seeing increasing activity in the passive segment with the launch of exchange-traded funds (ETFs) and index funds.

As of December 2019, the three-year compound annual growth rate (CAGR) for ETFs in India was 74.8%. This is approximately five times the three-year CAGR of mutual funds of 15.3%. Moreover, net new flows into ETFs have experienced a 59.8% year-on-year (y-o-y) increase from 2018.

The regulator and government have been the largest drivers of growth since the beginning. The biggest participant in India’s ETF market is the Employees Provident Fund Organization (EPFO), which has allocated 15% of its investible assets to ETFs.

Regulatory measures such as the categorization of mutual fund products, focus on digital channels, and adoption of a trailer-fee based model have provided the impetus for the leap toward passives. The scheme categorization rule has limited the scope for innovation in the mutual fund segment, while the new trailer-fee based model has resulted in fee pressures and caused the industry to consider low-cost products.

Furthermore, as managers struggle to achieve alpha through traditional mutual fund products amid the volatile stock markets, they have turned to passive investments such as ETFs and index funds in hopes of growing asset under management (AUM). Cerulli’s conversations with managers have revealed that, aside from the cost benefits associated with ETFs, digital marketing and advertising are expected to support the push of passive products to retail investors.

Retail demand for ETFs, however, continues to be nascent. One key reason for the low penetration is the commissions associated with distributing ETFs, which are not lucrative compared to other products.

The number of ETFs in the market stands at 85, compared to 61 in 2018 and 36 in 2015. Despite the increase in number, most ETFs are large-cap-focused and linked to equity indices. There is a need for diversity across asset class as well as within equity, such as mid-cap and small-cap oriented. While there are a few fund houses that offer these, a bigger segment of the ETF market is captured by those based on large-cap indices.

“Domestic investors could seek low-cost strategies as local players struggle to generate alpha in active funds, and asset managers will have to be prepared to cater to their needs. This can be further reinforced with investor education to raise awareness of these products as well as their benefits,” said Phoebe Yeo, associate analyst with Cerulli.

“However, scale is important in passive business. Despite boosting growth in AUM, low-cost products will dent investment management fees and weigh on profitability,” she added.