The active versus passive investing debate has raged globally for a while now. Passive investing, which involves replicating indices, provides a cost effective and simple way of investing money in the markets. It is very popular in developed markets and is gaining ground in emerging markets too. This analysis explores why active investing remains relevant in India while examining the evolving landscape that’s making passive strategies increasingly viable.
The Case for Active Management in India
India’s market structure creates several opportunities for active managers and investors to generate alpha through skilled security selection and research:
- Market Inefficiencies and Information Gaps: The Indian market exhibits significant information asymmetry, particularly in the mid and small-cap segments. With over 5000 listed companies but limited analyst coverage beyond the top 200 stocks, diligent research can uncover mispriced securities. This contrasts sharply with developed markets where hundreds of analysts might cover a single large-cap stock. Simply put, the Indian market is less efficient and that creates opportunities for active managers to exploit.
- The Undiscovered Universe: While passive funds typically focus on the top 100-200 stocks, India’s broader market offers a vast universe of undiscovered companies. This creates opportunities for active managers to identify future winners through bottom-up stock picking. Many of today’s large-caps were once underfollowed mid-caps that rewarded early investors handsomely.
- Corporate Governance Evolution: India’s corporate landscape is witnessing a gradual but significant improvement in governance standards. Active managers who can identify companies making genuine improvements in transparency and governance practices can capture the value creation before it reflects in market prices or index weights.
- Index Composition Challenges: Indian indices often have structural imbalances, with heavy weightage toward sectors like IT and financials. Active managers can construct portfolios which access emerging sectors that are underrepresented in indices. This becomes particularly relevant as India’s economy undergoes structural changes.
- Retail Dynamics: The significant retail investor base in India can create price inefficiencies through behavioral biases and short-term trading. Skilled active managers can exploit these inefficiencies while maintaining a longer-term investment horizon.
The Passive Perspective
Parallely, the case for passive investing in India is strengthening due to several factors:
- Progress towards market efficiency: Increased institutional participation, better research coverage, and technological advancement will gradually make the market more efficient. While the market is not yet as efficient as its developed counterparts, the gap is narrowing, particularly in the large-cap segment.
- Cost Considerations: Active management comes with higher costs. These costs can eat into the potential alpha generation.
- ETF Evolution: The growing liquidity in ETFs is making passive strategies more practical and cost-effective. The introduction of new ETF variants provides investors with more choices for targeted exposure.
Global Context
You can deduce from the above points that the success of active versus passive strategies will vary hugely with the kind of market.
Developed (more efficient) markets: In markets such as the US and Europe, high analyst coverage, sophisticated institutional investors, and real-time information flow make it difficult to find mispriced securities. This results in a significant advantage to passive strategies in these regions.
Emerging and Frontier (less efficient) markets: Markets with poor corporate governance or limited liquidity often require active management for proper security selection and risk management. India falls somewhere in the middle of this spectrum, with improving market efficiency but still significant opportunities for active management.
How does the performance compare?
To compare the strategies, we looked at the 3 year and 5 year annualised returns of ETFs based on two broad based indices – Nifty 50 and BSE 500. As expected, the returns of the ETFs are close to those of the respective indices in the given periods. We compared these with annualised returns of the median PMS in the same periods. All these returns are net of fees and pre-taxes.
As can be seen from the chart below, the median PMS produced alpha over both the index ETFs. In particular, it had a significant alpha of more than 4% points over the Nifty 50 ETF (which tends to be more popular). Due to compounding, this annual alpha produces a significant divergence in portfolio returns over years.
Looking Ahead
The future of investing in India will likely involve a hybrid approach:
- Large-cap exposure might increasingly tilt toward passive strategies as this segment becomes more efficient.
- Mid and small-cap segments could continue to offer opportunities for active management.
- Thematic and sector-specific investments might see a mix of active and passive approaches.
- The rise of factor investing and smart beta strategies could bridge the gap between pure active and passive approaches.
While passive investing continues to gain traction globally, India’s market structure still offers compelling opportunities for active management. The key lies in understanding where and when each approach makes sense. As the market evolves, investors would do well to consider both active and passive strategies as complementary tools in their investment arsenal rather than mutually exclusive choices.