Passive investments have gathered steam in India’s mutual fund industry, with assets under management (AUM) of India-domiciled exchange-traded funds (ETFs) surging 48.9% to INR4.02 trillion (US$54.2 billion) by December 2021. Growth was more than five-fold between 2017 and 2021.

Recent growth has been boosted by the stock market rally and buoyant net flows to India's ETF sector. In fact, across various fund categories, ETFs (excluding gold ETFs) topped the net inflows chart for 2021, raking in INR708.6 billion in net flows, surpassing the INR557.7 billion garnered by dynamic asset allocation funds. The latter has been riding high on managers' production promotion plans as fund houses recommend asset allocation strategies to investors to weather stock market volatility, high stock valuations, and low returns on fixed-income funds.

Some of these factors are also among the reasons for ETFs gaining traction in India. For instance, the strong stock market rally has led to concerns over future performance prospects, especially in the large-cap equity segment. Moreover, the proliferation of digital channels, the increasing use of direct plans, rising interest from first-time young investors, the new AUM-based total expense ratio fees adopted by the industry, and the entry of fintech firms focusing on the low-cost passive funds business have veered the industry toward ETFs, with giant active fund houses starting to embrace passives.

In terms of asset breakdown, equity ETFs are unsurprisingly the dominant class, contributing to four-fifths of assets. While the industry has seen the launch of fixed-income ETFs, these do not command a significant share of the ETF pie, because of investors' tendency to chase returns through equity investing. In late 2021, the Securities and Exchange Board of India permitted the launch of silver ETFs, and three such ETFs are being launched.

Apart from ETFs that invest in domestic companies, mutual fund managers are also offering investors access to global large-cap technology companies and innovation themes that are currently not available in the Indian markets, through fund-of-fund (FoF) schemes that invest in overseas ETFs. Mutual funds can invest a maximum of US$300 million per firm within the overall industry limit of US$1 billion for investments in overseas ETFs, and since the limit has not been breached, there are plans for FoFs to invest in overseas ETFs as they await new relaxations. Moreover, overseas ETFs offer access to emerging themes at low cost, and help achieve international diversification.

“Even as passives are expected to be in the limelight, investors are likely to use a diversified investment approach with a mix of active funds, across asset classes, for core allocation and use passives for satellite allocation,” said Leena Dagade, associate director with Cerulli. “While valuations appear rich in the large-cap segment and a section of the industry is concerned that future alpha opportunities could be lower than those generated historically, there are still market inefficiencies to be explored in the Indian stock market through active management, where fund managers’ expertise are needed.”