The global rise of passive investing
Charles Ellis, a leading figure of the American investment industry, wrote an article titled “The Loser’s Game” in the July 1975 issue of the Financial Analysts Journal. Forty-two years later, the article still makes for compelling reading. It was the first time that the case for so called “passive investing” was made. According to Ellis, the investment management business (he refused to call it a profession), rests on a basic but false belief—that professional managers can beat the market.
It took nearly 40 years from that article for the tsunami of index investing to hit global markets. Writing in 2016 in the same journal, Jack Bogle, founder of investment management company The Vanguard Group, gives us a perspective on the growth of passive investing. From 4% of equity mutual fund assets in 1995, passive funds grew to 16% in 2005, and doubled to 34% in 2015. But the even more important trend is that since 2008, index funds have accounted for 160% of the net flows into equity mutual funds in the US. What this means is that investors are taking money out of active funds and putting into index funds at an astounding rate—from 2008 to 2016, investors have sold $600 billion of their active holdings and purchased $1.6 trillion of passive funds.
When, if ever, will this tsunami hit Indian shores? While the popularity of index funds is growing in India, we are still at the single-digit level when it comes to assets invested in index funds. The Indian mutual fund industry has no Vanguard. The pioneer of index funds in India was Benchmark Asset Management, a company that started the first exchange-traded fund (ETF) in India. However, Benchmark sold its business to Goldman Sachs, which in turn sold it to Reliance Asset Management. Talk to most fund managers, and they remain convinced that India is an active investor’s market.
Why did it take until now for something like this to happen in global markets? An important but under-appreciated factor is a wave of litigation against companies for not investing pension assets in the best interests of their employees. Firms employ agencies called “record keepers” to invest employee pension assets. These firms in turn appoint the fund managers who invest the money. Starting in 2006, a number of lawsuits have been filed against record keepers for entering into indirect payment arrangements that drive up transaction costs for pension funds. According to data analysed by FT Ignites and Financial Times, over $400 million has been awarded in lawsuits pertaining to US retirement plans called 401(k)s.
The lawsuits, in turn, are a response to the asset management industry’s inability to deliver long-term returns. After the global financial crisis, pension plan participants discovered that their wealth at retirement was going to be much less than what they had been led to believe during their working lives. They put pressure on the mutual fund industry to reduce transaction costs and improve net returns, resulting in the movement of assets from actively managed funds that charge around 100 basis points to passive funds that charge a fraction of that.
This combination of higher transaction costs, pressure from investors and a failure to outperform index funds have together forced a trend that has snowballed into a major disruption of the global asset management industry. The industry is consolidating quickly, and young investment managers are having to learn new skills to remain relevant.
Why don’t we see this kind of pressure in India? Transaction costs are higher in India than they are elsewhere. A diversified equity mutual fund can charge a fee of 300 basis points. More surprisingly, even an index fund charges around 100 basis points. In comparison, a US index fund charges around 30. Performance analytics is still at a nascent stage in India. Mutual fund executives routinely compare their performance against the index, without pointing out that the net asset values should be compared with total returns, which include price changes as well as dividends.
Part of the reason for the lack of pressure on cost and performance is that we don’t have enough institutional asset owners in India. Globally, pension assets are “owned” by corporate pension plan sponsors, endowment funds and other types of firms that represent the beneficiary owners of assets. For example, the Employees Provident Fund and the National Pension System are asset owners. But most domestic equity assets are invested through mutual funds, where retail investors purchase units. Add to this the commission-based incentive structure where agents selling mutual funds receive their compensation from the funds themselves, and we have a situation where there is no one to apply pressure on transaction costs or even on the gross returns produced by asset managers.
Participants in the value chain of investment decision-making have a fiduciary duty towards the customers they serve. Too often, their desire for profits gets in the way of their duty to put investors’ interests first. The global asset management industry is ripe for change. However, change doesn’t happen on its own. Competitive dynamics in an industry can remain stable for a long time before changing suddenly over a short interval. The trigger for change can come from regulators, from technology or from new entrants trying to disrupt the industry. To understand whether we will see the rise of index investing in India similar in scale to the recent transformation in global markets, we must understand when and whether the triggers that drove change in other markets will come to India.
Vidhu Shekhar is country head, India, of CFA Institute India Pvt. Ltd.
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