Recent regulatory developments allowing mutual fund companies to offer passive equity-linked schemes (ELSS) could provide opportunities to prospective market entrants as well as existing small and mid-sized firms.

India’s mutual fund industry is showing a greater take-up of passive investing. In 2022, exchange-traded funds and index funds led net flows, raking in INR832.4 billion (US$10.1 billion) and INR793.6 billion, respectively. Furthermore, regulatory initiatives on fees and increasing usage of online platforms have put passive investing in the spotlight.

Since May 2022, the Securities and Exchange Board of India (SEBI) has allowed fund companies to launch passive ELSS in efforts to develop the passive fund industry. However, firms must choose between active or passive ELSS, thus limiting the product opportunity to only those that did not offer such products, or to new entrants. Between May and November 2022, only one firm—IIFL Mutual Fund—launched a passive ELSS. In the active ELSS space, there were two new launches in October and December.

In January 2023, the SEBI relaxed norms further by allowing fund houses with existing active ELSS to launch passive ELSS provided they halt flows into their existing active ELSS, including flows coming through systematic investment plans. At the time of writing, only one firm stopped fresh inflows to its actively managed ELSS and launched a passive ELSS on Feb. 14.

It remains to be seen how many more fund houses would consider halting their existing active ELSS to be eligible to launch passive ELSS, or if those with larger active ELSS would be keen to switch to low-cost ELSS options. Given the three-year lock-in period, fund managers can take efficient stock selection decisions to generate alpha compared to market-linked returns that index-tracking passive ELSS can offer to investors. Another point of consideration is the better fees earned in an actively managed ELSS than in a passive counterpart. The take-up of passive ELSS also depends upon investors’ reactions to the new income tax regime under the government’s union budget for 2023-2024.

In the initial years, Cerulli believes passive ELSS could offer prospective market entrants as well as existing small and mid-sized firms the opportunities to attract investors, due to low-cost nature of these products. As the SEBI continues with its efforts to drive down the fees of mutual fund products, industry dynamics could probably lead a few more fund houses to consider launching passive ELSS. As and when this happens, firms with more assets would be in a better position to ride out fee compression.

“Passive ELSS is a significant development to look out for in terms of how the industry manages to cash in on this opportunity as the combination of low fees, tax incentives (depending upon investors’ decisions to choose between old and new tax regime), and stock market-linked return potential could help lure investors,” said Leena Dagade, associate director with Cerulli. “Young and first-time retail investors could make use of this mutual fund vehicle to embark on their investment journeys. However, more investor education would be needed to improve the take-up of these products.”