Fifty years ago, there were no index funds; all assets were managed actively. The subsequent shift of assets from active to passive management in U.S. and European markets may count as one of the most important developments in modern financial history. Our intent in this paper is to explore how and why this transformation took place in the U.S., why a similar transformation is beginning in India, and how India can look to the U.S. as an example of passive investing’s future growth potential.
The rise of passive management in the U.S. and Europe was the consequence of active performance shortfalls.2 In India, we observe the same shortfalls coupled with unique local factors, which can be attributed to three sources: cost, increased regulatory oversight and government initiatives, and the skewness of stock returns.
At the end of March 2018, the size of the Indian mutual fund industry was INR 21.36 trillion (approximately USD 300 billion), of which about 3.8% of assets were managed passively (see Exhibit 1).3 At this passive AUM share, a 100 bps cost differential (between active and passive) results in annual savings of INR 8 billion (approximately USD 115 million) for Indian investors and asset owners.
THE RISE OF PASSIVE MANAGEMENT IN THE U.S. AND ITS EVOLUTION IN INDIA
The U.S. has witnessed a significant growth in passive investing due to headwinds for active management in the following areas: cost, the professionalization of investment management, market efficiency, and the skewness of returns.4
Underperformance by active managers is not a new phenomenon and has been documented as early as 1932 by Alfred Cowles. It still holds true, as seen in the S&P Indices Versus Active® (SPIVA® ) U.S. Mid-Year 2018 Scorecard results (see Exhibit 2). S&P Dow Jones Indices has been the de facto scorekeeper of the ongoing active versus passive debate since the first publication of the SPIVA U.S. Scorecard in 2002. Over the years, we have expanded the scorecard’s coverage to Australia, Canada, Europe, India, Japan, Latin America, and South Africa. The results have been almost uniformly discouraging for the advocates of active management.
The evidence, over many years, is clear: a large proportion of active funds underperform their respective benchmarks over different time horizons. This is not unusual—in fact, over the history of the global SPIVA database, underperformance is far more common than outperformance.