How the rise in passive investing in India drives sell-side automation

May 15, 2024

Key Takeaways

  • Passive investing in India driven by growth of retail investors
  • Passive investment cuts costs and saves time, but is not a risk-free strategy
  • Sell-side firms must rely on automation to stay competitive

India has been at the forefront of the global rise in passive investment.

Assets under management of exchange traded funds (ETFs) a popular investment strategy, have grown to more than INR 6.3 trillion (USD 75.3 billion) from INR 351 million (USD 42.15m) 10 years ago.

The USD 4 trillion stock market, much like the wider economy, is booming, with India recently pushing out Hong Kong as the world’s fourth largest capital market. As we wrote previously, thanks to a popular technological infrastructure called the Indian Stack, markets have been opened to millions of retail investors. This has driven the growth in passive investing, primarily through ETFs, and as a consequence, brokers are investing in advanced trading tools and integrated solutions to cut costs and meet this seemingly insatiable demand.

What is passive investing?

Unlike active strategies, where investors regularly buy and sell stocks, passive investing through index-tracking funds aims to mimic the performance of a specific market index. Championed by experts like Warren Buffett, it is lauded for its simplicity. This strategy is less time-consuming and provides built-in diversification, as these funds typically encompass a wide array of stocks, potentially reducing risk. Moreover, it minimizes trading fees due to infrequent buying and selling, allowing investors to benefit from long-term, inflation-beating returns through compound interest.

But, like all investment strategies, it carries inherent risks. Returns can vary widely year to year, with some years experiencing significant declines. Additionally, the growing popularity of passive funds may lead to inflated asset prices, exacerbating market downturns. Investors must also consider the possibility of achieving minimal or no gains within their investment timeframe, especially if the market takes a long time to recover from a decline.

Nevertheless, passive investment continues to go from strength to strength. Assets under Management (AUM) at the end of last year for passive investments (index funds and ETFs) stood at INR 8.5 trillion in India and USD 11.63 trillion globally, with 10-year AUM CAGR rates of 56% and 16.9%, respectively, stock exchange data shows.

Size: USD 11.63 TrillionSize: INR 8.50 Trillion
10 Year AUM CAGR ~16.9%10 Year AUM CAGR ~56%
73% Equity, 17% FI, 10% Commodity & others73% Equity, 24% FI, 4% commodity
70% USA, 16% Europe, 11% Asia Pac, 3% othersEquity passive funds is now ~22% of total MF equity AUM
11,869 ETFs/ETPs, from 731 providers listed on 81 exchanges in 63 countriesIn all 361 Equity and Debt passive funds in December 2023 (8 in 2008)
Net inflows reached $974 bn YTD at the end of December 2023Nifty 50 has 36 passive funds (17 ETFs and 18 Index funds) with AUM ~Rs.3.11 trillion

Source: ETFGI & AMFI AUM data. Includes AUM of equity, debt and commodity ET6Fs and Index funds; Data as on December 31, 2023

What’s driving passive investment in India?

Some reports in recent years have put the popularity of passive funds down to the underperformance of active funds, though the flexibility of active strategies during bouts of market turmoil provides an advantage to professional and experienced investors.

A 2021 report by CRISIL stated, ‘Our analysis – that actively managed funds tend to lag benchmarks during bull phases and perform well during the bear phase – is corroborated by the IFA community and industry leaders.’

Other, local factors have helped the rise of passive investing. These include passive managers’ lower costs compared to those of their active peers, and regulatory developments, such as India’s capital markets regulator SEBI reclassifying mutual fund schemes, or plans to exclude equity-oriented passive funds from the 25% investment cap in group companies.

In addition, government measures, introducing ETFs to a broad spectrum of new investors to emphasize the advantages of low-cost options for engaging in equity markets, have also played a role.

Former deputy head of ETF at Nippon India Hemen Bhatia adds that passive investments make asset allocation easier for investors as they provide a broad exposure. Fintechs, growing financial awareness and transparency are further drivers, given that investors can now access platforms to help them compare funds’ costs and returns.

Impact on sell-side: more need for automation

As investors increasingly gravitate towards passive products, which have lower expense ratios than active funds, sell-side firms will increasingly have to rely on automation to cut operational costs and remain competitive.

Passive funds, due to their ‘buy and hold’ nature generate lower trading volume, meaning that sell-side firms, whose revenue relies on trading commissions and brokerage fees from active trading, should modernize and automate their processes to make efficiency savings.

Furthermore, sell-side firms can stand to gain from automation as they optimize their operation and enhance efficiency to adjust to changes in market structure, such as market liquidity, driven by the surge in passive investment. And as they stretch resources to keep up with more complex regulatory reporting and shorter settlement times, firms using automation will generate fewer compliance-related errors.

Market participants should position themselves for even more growth, as institutional investors also pile in to passive investing and reap the benefits of lower expense ratios as more diverse ETFs and index funds are launched.

ION Markets

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