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Mutual Funds

Podcast #21: The amazing rise of passive and what you need to do about it



“When you talk about bubbles, right from the Tulip mania (1637) to the housing bubble (2006-07), all of these bubbles were fueled by greed. But passive investing seems to be a natural evolution of markets where investors are realizing that there is no point in paying top dollar for active management and research, because 99% of the fund managers over the long term are not able to beat the index returns”

Is passive investing the next bubble? It it making investors insensitive to valuations? Is it distorting the capital flows to the market? In U.S., the market share for passively managed funds has risen to about 50 percent, but what is the number for India? Where do we stand?

Deepak Shenoy (CEO) and Aditya Jaiswal (Analyst) answer these and a lot more questions on today’s show.

Stay tuned!


(The transcript has been sourced from a premium transcription provider. Yet, it may contain inaccuracies.)

Aditya: Today we’ll be talking about passive investing. Is passive investing an evolution of markets, or is it just another bubble? Is passive investing getting out of hand? In the US, the market share for passively managed funds has reached around 50%. But what about India? Where do we stand?

Aditya: We’ll answer these questions and a lot more in today’s show. But let me first welcome Deepak Shenoy, hi Deepak, welcome to the show.

Deepak: Hi Aditya, it’s great to be on the show again. Lovely evening in Bangalore, we would love to talk about this subject, which is I think is a subject that is a close matter to a lot of people, especially because even at Capitalmind, we used to call ourselves with the tagline ‘active investing’. We’re actively passive at times, why and what and how, let’s go through the rest of the thing you have for us in the podcast.

Aditya: So Deepak, we’ll divide this podcast into two sections. So in the first section, we’ll try to answer the question whether passive investing is becoming a bubble. And in the next section, we’ll talk about how passive investing works, and what is the flow of money, and how can we do passive investing, like passive/passive, active/passive.

Aditya: Here’s my first thought, you know that the market share for passively managed funds in the US has reached over 50%. And as we discussed in one of our previous podcasts, that Japan is actually printing money and buying index funds, and ETFs. So do you believe this is leading to some sort of a distortion of capital flows in the market? Some people even say that this is leading to death of thinking investors, and this is leading to a new class of investors who are insensitive to price and valuation.

Deepak: So Aditya, I think there’s a lot of interesting, let’s clarify first what passive investing is. If you’re talking about passive, you’re saying I want to buy the top 50 stocks by market cap, we call them the Nifty 50. Awesome, this is great. Why do you buy the top 50, because you believe the top 50 will continue to be very good. What if some of these stocks are not part of the top 50 tomorrow? Well, you sell them and buy the stocks that replace them. Just always be in the top 50, so you’re now in the top stocks in the exchange.

Deepak: If you consistently do this, then the stocks that are consistent performs over a very long period, stay in the index, give you great returns, you replace the losers automatically, not taking any personal decisions on oh, Yes Bank will recover, so I should keep it. No, if Yes Bank goes out of the index, you take it out of your portfolio, if Yes Bank stays in the index, no matter how bad you think it is, you keep it in your portfolio.

Deepak: The point about indexing has been, once you don’t have to make these decisions, and these decisions have come out of an algorithm, the algorithm can be as simple as highest market cap, it can highest earnings. You can have an index which is based on some kind of mathematical formula. And then how an ETF or and index fund that chases that index, that buys stocks in the same proportion as that index, you don’t need to think which stocks to buy. You don’t need to analyse the fundamentals. You don’t need to see whether this stock has corporate governance issues. You’re just going to blindly buy the stock.

Deepak: The fact is that this strategy has beaten a lot of active managers over years and years and years, simply because this is like in most cases where there are market cap weighted indexes, that’s where the maximum amount of capital is. If you have a market cap weighted thing, that means I will always buy Reliance because it’s the top market cap. If Reliance falls out of grace, then you will sell Reliance and buy something else. The top stock of the index in every decade has been different, it used to be Reliance, it then became TCS at some point, at some point it went to ITC, came back to Reliance. So it has actually shifted, the top set of stocks, have shifted over the years, some of them have gone out of the index temporarily and come back. Whatever happens, you’re now with the top 50, or top 100, or whatever top level that you have.

Deepak: A market cap weighted index is like a momentum index, you buy more of the stocks that are going up, because they’re up and they’re up because they have the highest market cap. Some of this leads into a self fulfilling prophecy, because if more money comes towards the top set of stocks, those are the prices that will go up, and therefore those are the prices that will not go down because no, these people are not selling. And therefore, momentum with these stocks, it builds momentum, you continue to buy or buy more, as more money comes into the index fund.

Deepak: There is a perverse incentive over here to not care about fundamentals, that means I don’t care. So what does an index fund manager work for, if somebody gives him a policy that says, I want to triple my manager’s compensation? What should the index fund manager do, because he’s not like, listen, if you triple your compensation, I’m going to sell your company from my fund. You can’t say that. The manager on the other side knows that, he’s like yeah, you can’t sell it.

Aditya: Exactly.

Deepak: So you can tell me, you can scold me, I’ll still give you a listen, and I will still triple my compensation because even after tripling my compensation, you can’t sell me.

Aditya: You can’t do anything.

Deepak: So who can sell me? The active fund manager. So I start ignoring the passives, and giving a lot of power to the actives. But at some point, if the active managers become a tiny percentage, maybe 10%, 15%, versus 85% is passive managers, I don’t even care about the actives, because if they don’t sell, or if they sell, or if they don’t buy-

Aditya: That doesn’t impact me at all.

Deepak: It doesn’t affect you at all, so you’ll just stop there and say, okay guys, I’m just going to do this thing, and nobody will oppose me. The passive manager has no incentive now to actually vote for or against a proposition, he’s just going to say okay, what is everybody else voting for? Let me vote in that direction, so just keep the least path of resistance.

Deepak: This is the perverse incentive that happens in such mutual funds. And there’s also perverse incentives that can help in building up this. For instance if I was a dirty, rotten, scoundrel, there are a lot of dirty, rotten, scoundrels in the market, if I was one, if I were the kind of person who’d say, listen, let’s do this, let’s take this stock, which is good, but it’s not in the index. I will buy out all of the shares in the market, as much as I can, basically pump it. So pump it! Pump it, get other people to buy it, make its market cap say 100,000 crores. Once it reaches that, you know that within six months or eight months, whenever there’s an index reshuffle, they can not ignore the fact that this company has a lot of shares, it is listed and its market cap is 100,000 crores, its free float market cap maybe high enough, and you know that it will get into the index. If not now, six months from now. All you do is hold.

Deepak: Now you hold a majority of the non promoter shares, and you keep pumping the stock up. When it reaches, gets into the index, you know that these big passive index funds will buy.

Aditya: Exactly, true.

Deepak: And then you sell to them, and walk away with a profit, because they will have to buy and hold at that point. If there are not enough active managers who will short sell the stock or who will sell the stock and bring the price down, and therefore get the stock to be taken out of the index, there is no reason why this stock will ever go out of the index, because index fund managers get more money, they just buy more of the stock. There is no reason for the stock to fall, at all. It’s only speculators and active investors who will actually truly help discover price, the passive guys will not.

Deepak: So there is a huge perverse incentive in this. And there will be a point at which people start talking about this as if it’s like the same way that people protest against shenanigans, they will talk about passive managers, these people are a blot on society, they’re not helping the price discovery and all that, that will happen at some point. We don’t know where that point is, but that perverse incentive exists, because incentives drive behaviour. At some point, people will demand better behaviour. You can not have apathetic fund managers, you can not have apathetic governments, you can not pretend that just because I’m a passive investor, that I have no say in how the company is being governed. At the same time, a manager can not say that just because all my investors are passive, I will not care about their well being.

Deepak: So there will be a point of convergence, I don’t know where that point is, but what you said it’s true, that there are sets of perverse incentives. Are we there today? We’re not necessarily there today. And there is no reason why should believe that this is not already happening with active managers, some of whom sometimes get paid to buy stocks. And active fund managers, we have heard of the stories, and possibly some of them are true, that some active fund managers will get paid on the side, just to purchase a stock in their portfolio, because they are active fund managers. Now this could be institutions like insurance companies, it could be mutual funds, it may be a pension fund, but there is no saint in the active management fund industry either, and even they have not done their job well, in terms of keeping governance in check.

Aditya: Exactly. Let’s move to the next section, where we talk about the bubble. A lot of people have raised this question, whether this is becoming a bubble. But I differ, because I believe if you talk about bubbles, right from the tulip mania, to the housing bubble, all of the bubbles were actually fueled by greed. But in this case, this seems to be a natural evolution of markets, where investors are realizing that boss, there is no point in paying top dollar for research, because 99% of these fund managers over the long term are not able to beat index.

Aditya: So here I don’t see the greed. If the greed is not there, then how come is this a bubble?

Deepak: So if we were to just say that the selection of passive fund because of performance is a bubble. I think that would be a wrong thing, because at some layer, we do this for restaurants, we do this for shopping, we look at stuff that has high ratings on Amazon, or we look at Zomato and say which is the best restaurant around me, those are also determined by other people’s behaviour and ratings, and things like that. You’re also going in the stock market and saying, listen, whatever is the highest market cap, which means a lot of other people own it, I want to buy that.

Aditya: Exactly.

Deepak: So it’s just a natural extension of saying, I will go and check all the companies and the fundamentals myself. Here I’m saying, no, no, I’m assuming somebody else has made a good decision, I’m just going to-

Aditya: And what is the cheapest form of instrument available to buy it?

Deepak: Yeah, and it’s cheap because while doing so active managers take a humongous pay. If you look at the HDFC AMCs financials, which is the asset management company, a significant portion of its earnings after it pays out commissions is paid out to its own staff and the managers. Now this is not because they don’t earn it, of course they work hard, they completely deserve their money, but if the mutual fund that they run is not consistently beating the index itself or a combination of indexes, you begin to question, if you’re not then why can’t I just put a computer, make it buy all the stocks in the proportion of the index and just let me have the index.

Aditya: No fancy stuff.

Deepak: You do this, you remove the compensation of the manager, and therefore your costs of the mutual fund company itself, become substantially lower. They can obviously lower the cost that have been charged to the fund, and earn the same absolute profit. So if I wanted to earn 30 crores of profit, I could earn 100 crores and pay 70 crores to my manager, or I could only earn 30 crores and have no managers, which is a computer. So my fee fell from 100 crores to 30 crores, to make the same 30 crores of profit. Effectively I could reduce the net charges.

Deepak: The bubble as a term actually has come from the fact that there are consequences, and those consequences are similar to bubbles. Because when there’s too much riding on one part of the equation, you do create an issue. Now if you look at LTCM, which was Long Term Capital Management 1998, it was doing something very simple. It was buying say 9 year bonds and selling 10 year bonds, or the other way around, whichever it mattered. The idea was that the 9 year bond and the 10 year bond should not differ too much in price. But in reality, the pricing of the instruments was very different, and that arbitrage gave result to a price differential that was harnessable. So I could say, listen I could buy one and sell the other, one is 9 years, one is 10 years. At some point they may come close to converging, and I will result myself in a profit.

Deepak: This has actually worked out true in Microsoft Excel, if you do a back test and all that stuff. But what happened in reality was a big disaster, not because this didn’t work, but because LTCM got too big. It was so big that it was threatening to bring down the entire financial system in 1997, 98, whenever that was. Because LTCM was so big, that everybody knew that it had these positions, and even if they widened in price, even a little bit, then LTCMs entire capital was getting wiped out in just the mark to market or margin payments that they were required to do. This was not a bubble, it was just a mathematical anomaly, that what works at small size does not work at large size.

Aditya: You reach a scale where your actions also influence the outcome, right?

Deepak: Yes, reflexivity in a way. So in the sense that, what you do has a different consequence in small scale and a different consequence in large scale. Now what happens in passive, why does it work? One of the reason it works is because active managers find the right stocks, they pump the money into the right stocks, and then the stock prices go up. These passive managers piggy back on that. They say, okay, you selected the right stocks, I trust you, I just want to buy them blindly. If you sell the stock, the stock price will fall, it will fall out of my radar, because I’m using prices and market cap as a filter, and then I will sell it.

Deepak: What happens when passive becomes greater than active? Much greater than active. The active manager suddenly realizes that his actions of analyzing balance sheets is stupid, because the money that’s flowing into passive is greater than the money that’s flowing into active. So he can sell a stock, the passive manager will still go buy it, because there’s a lag between the time he can sell and the price fall, versus the time that is actually removed from the index, that could be six months. Meanwhile, the passive manager, I could sell 10 crores of a stock, its price could fall 5%, the active manager may get 100 crores and buy that same stock and the stock goes back up 10%. So I look stupid, I’ve lost all my money selling the stock which I think is bad. The passive manager doesn’t care, he’s brought the stock price, it’s gone up, he feels even more justified in his buying the stock in a way, and everybody is happy. The stock may actually be bad, there’s no price discovery happening here.

Deepak: This is a consequence similar to a bubble. In a bubble, people buy too much out of greed and speculatory purposes, here the buying too much is not because of greed or speculative purposes, it’s simply that there’s so much sitting on one side of the equation and not enough on the other, that there’s no check and balance. The checks and balances system has stopped to work, and therefore it causes a similar action.

Deepak: So when you have indexing reach extreme peak, there will be a point at which it stops working. I’ll tell you what point that might be, and that point maybe that when index funds become the only things in town, or they go more than 75% of the assets, and then people start taking out money. Now stocks will fall for no reason, because now they are 75% of the market. The active guys will say, no, no, I should buy this now, it’s come to a great buy point. But no, money is not coming, because more money is going out, and when stocks fall, people who have lost money, take out more money, and they keep taking it out, keep taking it out.

Deepak: At some point, it will take some time for this to happen. The flip has to happen, the active money flowing back to active, has to now overshadow the amount that is flowing out of passive. But that is not going to happen, because who will invest in an active manager who is buying stocks as they’re falling and their prices are falling even more, think about it. The stock is at 200, the active managers refuse to buy it. People got out of passive funds, for whatever reason, they wanted some money, there was a liquidity crisis, people lost jobs. The market starts to fall, the market continues to fall, fall, fall, and this 200 rupee stock has now fallen to 100 rupees. Value managers say it’s okay, the active managers says great, now this is the time I’ll buy, I’ll put my 10 rupees, I don’t have a lot of money today, I’ll put my 10 rupees and the stock will start to perform.

Deepak: But more money is coming out of passive funds, the passive manages are selling more and more. As they continue to sell, the stock that was 100 has now fallen to 50. The active managers performance is also bad. So in a way what’s happening is the active managers looking at themselves and saying, oh my goodness, I though this was a great buy at 100, now why is it at 50?

Deepak: At some point, this results in such crazy actions, in will result if it’s too big, that even active managers won’t get money and passive managers won’t get money. And this is the time when governments will start to actually, RBI will start to act, and so on. In the West, it’s already happening. You’re seeing the Japanese central bank print money to buy stocks, and that is crazy, because they’re trying to keep the market afloat in a way. And everybody wants this, because they don’t want their portfolio values to fall, they don’t want their retirement nest eggs to fall. So everybody says, yeah, yeah, go ahead, print money.

Deepak: The bubble really is in another phenomenon, which is in the printing of money. Maybe it will outlive me, I’m much older than you, so probably will. But it may not be that I live long enough to see the end of this money printing exercise, because they can just keep doing this forever, and you will not know, and you will actually tell them that they should continue to do this. I could stupid enough to stand here and say this is not how it’s supposed to be done, but it’s been done and the world has not come to an end, and it has been done for the last 10 years. So who is to say that the end is tomorrow?

Deepak: Same thing for passive, is the end tomorrow? I don’t know. Will it continue forever? I don’t know. It looks like there is no reason for it to stop, as long as money printing is going to exist, passive may continue to flow, see funds flow towards it, and if funds flow out of it for any reason, the government will print more money, and buy the passive stocks. So no, that’s where it is.

Aditya: So Deepak, let’s move to the other section, where we try to understand passive investing. My question is, as we discuss that the market share in the US has reached 51%, interestingly 10 years ago, passive fund in the US were just 25%, so in 10 years they doubled, from 25% to 50-51%. But what about India? Where do we stand? If you look at the total AUM, so this is all AMFI data, if you look at the total AUM in India, it’s about 26.5 lakh crore, out of which equity mutual funds hold around 8 lakh, next is the debt mutual fund, around 7 lakh, so these are approximate numbers, liquid funds another 5 lakh, and then ETF at 1.77 lakh.

Aditya: So let’s focus on this number, ETF, which is 1.77 lakh. Let us add US ETFs that track India, so that is another 1.5 lakh crore. We can say that total AUM of passively managed funds in India is around 3.25 lakhs. Now compare it with the free float market cap of all the companies listed in NSE, that will take you to around 5%. So the comparative figure for India, compared to the US where they are at 51%, the comparable figure for India is at 5%.

Aditya: If you talk about a bubble in the US, I may agree with you, but India, bubble? I believe this is just the beginning, like where is the bubble?

Deepak: That’s true. See, the thing we have to see is where is this money coming from? Even this 1.7 lakh crore. There is 65000 crores in the largest mutual fund in India, that is the SBI Nifty ETF. The second highest is Kotak Multi Cap, which is at 29000, it’s more than double the second highest mutual fund. The 65000 crores has almost entirely been placed by the Employees Provident Fund Organization. So it’s not retail that’s been buying this, it’s been institutional buying.

Deepak: A number of other ETFs have a very high, index funds also, assets under management. For instance, there’s a US ETF called I think INDA or INDI, one of them, which actually manages around 6 or 7 billion dollars. Now 7 billion dollars is 49000 crores, 6 billion is about 42, these two funds and there’s something called EEM, Emerging Markets Index, this has over 60 billion or some crazy number like that, of which about 10%, I think VW, one of the two, Vanguard Emerging Markets Index, which has so much, and 10% of that fund is India, which is also is about 50000 crores by itself. So I think three of four ETFs account for-

Aditya: That 1.5 lakh crore.

Deepak: These are extremely large mutual funds, that have some kind of institutional access. Of course, INDA and INDI are listed in the US, so the 8 billion number sounds very big, but it’s actually really small for most US funds.

Deepak: But having said this, where we are with respect to a bubble size of things, would be to compare these instruments to the free float, non-promoter market cap of these companies. India’s total market cap is 150 lakh crores, half of that is promoter, 75 lakh crores is non-promoter, out of which 3.5 or 3.75 is in ETFs or in index funds. This is piddly, this is tiny, and if I say that 10% of all index funds own today HDFC Bank, that means HDFC Bank’s ownership is only 30000 crores. HDFC Bank’s market cap is roughly 7 or 8 lakh crores, so even the highest rated bank company, the ETF owns less than 10% of that company, and that is really small overall size. And this is all ETFs put together, it’s not a single ETF, all ETFs put together are a very small portion of these companies’ market cap.

Deepak: Now remember, if you look at the number of shares that are owned by different parts, foreign institutions as a whole, including the ETFs, actually own a significantly larger share than the promoters themselves, that is the promoters of HDFC, which is about 24%. So the foreign institutions probably own 55, 56% or more of the bank. So it’s not really a bubble in any meaningful sense of the word. It’s a bubble if you were to describe such things as a bubble, it would be foreign institutions as a whole. Foreign institutions as a whole hold roughly half of the non-promoter market cap in India, around half. That means we haven’t benefited from our markets, we used to own all of the non-promoter market cap before 1992, we gave half of that away to foreign investors. But the point over here is that index ETFs are not really big in India, it’s really small.

Deepak: There’s one significant point, recently this ETF becoming really big has impacted markets. We have seen that the last three months, I don’t know if you have seen the data, and I think we plotted the data in a graph, AMFI releases daily net inflows into every category of funds. If we look at equity funds as a whole, the last three months, that is October, November, and December, the inflows into ETFs and index funds overshadows the amount of money that’s coming to equity mutual funds that are managed.

Aditya: Which is very impressive.

Deepak: Which is very impressive. And in December, it was a big number, 8000 crores coming into mutual funds, everybody was happy, fantastic. Do you know how much came in ETFs, just ETFs was 12000 crores. So active mutual funds was about 8000 crores and index mutual funds about 12000 crores. I don’t know who’s putting in that kind of money, it’s probably not the EPF, but it could be, we have no idea, we’ll know only perhaps within an RTI request, maybe 10 years later.

Deepak: But the point over here is it’s happening here slowly, that inflows are overshadowing. Even if you took the whole of last year, and the whole of last year is not representative, the whole of last year mutual funds that were active got about 70000 crores. I’m talking only of the non-hybrid, not balances, so I’m just talking about pure equity funds. They got roughly 71000 crores in net inflows. The same number for ETFs was 50000 crores.

Aditya: That’s very close.

Deepak: Now, it’s reasonably high, because earlier you would have thought, they’re only 3% of the market, why should we bother. But the answer is, as flows towards index funds increase, at some point overshadows your regular direct equity funds, you will actually find that at some point this catch up will start to happen. That may still be a long time away, but all it has to do is get to a point where this incentives get misaligned, and things start to move.

Deepak: Remember, it’s not just India, it’s worldwide. It could be a combination of MSCI India as an index and the funds that follow it, it could be the Nifty 50 and the funds that follow the Nifty 50, it may be the Nifty 100 at some point in time. But this pressure for it to become too much or a bubble, it’s really I think while it’s a while away, it is worth tracking.

Deepak: I’ll tell you why also, even if you’re an active funds manager. As more and more money comes to passive funds, why not just buy the top stocks, which are relatively heavily owned? I’m not saying that’s the only way to do it, but consider that I could buy say stock like HDFC Bank. You think that HDFC Bank has a promoter ownership of only 24%, why do we care are promoter ownership? We say okay, promoters are not going to sell their shares, so only the rest of the shares that are liquid that will freely trade in the market. But index funds also don’t sell their shares for a considerable portion, as long as they’re getting money from the economy, from people who are investing in them, they’re going to hold those shares for a long time. Neither are for a large part foreign institutions, because they also get money from their investors, so mutual funds, institutions, and all that stuff. So it’s only a small portion of stocks that get are freely traded.

Deepak: As more and more comes to index funds, they have to buy these top stocks. Because they are buying these top stocks, even the active fund managers, in order to not underperform, are buying the same.

Aditya: Exactly.

Deepak: HDFC Bank is a top held position in roughly 90% of all active, large, mid cap, and sometimes even in small cap mutual funds. It remains that, because these funds realize okay, if money keeps going to HDFC Bank, I might as well own a little bit so that I also participate in that a little. So if it’s 10%, I’ll take 10%. Because of this, it actually makes sense for an active manager to simply just chase that performing stock, because they know that as more and more money comes into active mutual funds, that is where the picture is.

Deepak: Now also think what happens when there’s a change. If you change a stock, one stock goes out and the other stock comes in, on that day there will be a big move to shift out from one stock and shift into another stock. We’ve traded something like this, because the MSCI index, at some point the India index there was I think Kotak Bank was about 3% of the index. We noticed that because of some FI ownership laws, there was a massive shift by MSCI to say I will take out Kotak because it does not allow foreign institutions to buy. When you take out Kotak back, from at that time India funds has about 20000 crores, 3% of that is 750 crores. 750 crores was 5x the trading volume of Kotak on any given day. So given that, you knew that the price would be under pressure. You could guess when, because the index tells you the dates at which it’s going to happen, and you go short Kotak. And then when the selling is done, you go long Kotak again, because there will be active managers come and buy, because India is not permeated only by passive.

Deepak: So it was interesting active strategy to track. It’s not necessary that it will always work, but recently I think we have seen once case, where the government replaced the CPSE ETF constituents, two of them, by three others, and the two which were removed or reduced in weight, fell considerably on one day, and the other three stocks rose considerably on one day. That was just a one day phenomenon, but it’s an interesting play this action has got to happen. Somebody has to sell these stocks and buy some other stocks, and if the amount they buy and sell is significant compared to the stocks daily volumes, you’re going to find that there’s an opportunity to participate.

Deepak: There’s another one that’s coming soon, we’ll talk about it at some point.

Aditya: So Deepak, the way I look at it is, there is a tsunami, and if you’re being a contrarian, you should know that you are betting against liquidity, isn’t it?

Deepak: When you say against liquidity, you mean against the passive volumes?

Aditya: Exactly, yes. And my other point is, today one can be actively passive. The sheer instruments that are available, you can buy a Nifty Index, and then you can buy Nifty Next 50, you can buy Nasdaq, then Gold ETF, Bharat Bond ETF. So there are a lot of ways to do this, isn’t it?

Deepak: Yeah. So the good thing about some of these mechanisms is they give you diversification in a single instruments, because otherwise I have to buy 50 stocks and I have to keep rebalancing, it’s such a pain. I just get a single instruments. Of course, I could use an active mutual fund itself, but as we’ve seen, a lot of active mutual funds change their colors according to the season sometimes. So for a long time, small cap funds were only buying large cap stocks, large cap funds were buying small cap stocks.

Deepak: A lot of this has been regulated by SEBI now, but what that has done is made most of the large cap funds equal to each other. They’ve given them 100 list of stocks and said choose among these. Choose among these is very easy to say, but some of them will get it right, some of them won’t. You get 100 people to choose 30 out of 100, some of them are bound to be outright winners, at some point, and some of them will be consistent also.

Deepak: The problem really is now passive becoming the area of a single instrument being attractive, is that now going to be selected as a passive fund or an active fund. Till now, I think distributors have been saying let’s go active, let’s go with big name fund manager A, or big name fund manager B, or big name mutual fund A, big name mutual fund B. In the US, already people have started to say, forget big name, forget mutual fund, just go with index, S&P 500, bond index, this, that

Deepak:Once you get down to that level, it doesn’t matter who’s managing it, and you’re saying that I believe in the top 50 companies in India. It’s a much easier proposition for someone to accept, than to say I believe in this fund. We like to believe in people. We won’t say, I will take the top 10 players of the world at any point in time, and I’ll bet all my money on those guys. How does it matter?

Deepak: But we don’t get this intuitively, we like people. We say, this fund manager, he will sit outside of the company 24 hours, he will see how much orders are going in, how much coming out, he will do additions and subtractions, he will buy the right stock.

Aditya: We are wired that way.

Deepak: We are wired that way. I think if you were to act and say, investing is not my primary business. I just want to somehow participate in this fancy thing called the stock market, because in the long term it apparently beats inflation, so let me just put my money there. How do I care whether I get 25% return or 22% return or 18% return, as long as I am getting that return by participating in the top stocks of India? I am betting anywhere on the top stocks of India, and I want to buy the top stocks of India. If that is my objective, just buy that.

Deepak: If not, a bond ETF, what the recent bond ETF is doing is telling us that is an index called something, that index is of course quasi constructed, but the idea of the index is very simple. I want only India PSU, Indian Government kind of exposure. I don’t want risk. There is risk in Indian Government exposure, but we won’t talk about that. But it’s giving the illusion of low risk, and this index has been constructed only so that this ETF could be constructed. The ETF has been constructed so that these companies can raise money at relatively low price.

Deepak: It’s just simplicity that drives decision making in passive, which I think is a very elegant point. It’s not to be written down, simplicity has super attraction in the long term. Ask anybody who has 26 mutual funds with them, and after 10 years they’re looking and saying, I need a guy who can now figure out who all these mutual funds belong to, and why did I buy them. You should ask me, I don’t remember that. I had SIB, then somebody told me change this SIB, I changed it, and then somebody else told me change this SIB, I changed that also. But if sell all this, I will have taxation, I will have this, I will have that, I don’t know why these funds are in my portfolio.

Deepak: But if you buy the top 100, you just keep buying it. It’s like buying the same mutual fund over and over again, and you just two or three, that’s it. So it’s an attractive proposition.

Aditya: So Deepak, in closing, I would just like to ask how do you see things going ahead? Because it took US 10 years to go from 25 to 50. Now they were at 25, we are not even at 10. So how do you see this panning out?

Deepak: I think coming back to one more point about what we’ve discussed, we don’t have it in India yet. In the US, you have ETFs about everything. You have smart beta ETF, not so smart beta ETFs, and all sort of, anything, 3x leveraged ETFs.

Aditya: I don’t understand how can people call smart beta as a passive product?

Deepak: The bond ETF in India is similar to that. It’s an active product, they took that active product, made an index. Of course, they will argue that it’s not, but it is really. It’s just a selection of stocks based on a criterion that’s very, very loose, and the index ETF just mimics it. So a lot of people say okay, I’ve created this strategy and I’ve got somebody to make an index against it, and I will now run that strategy as an ETF. And I will charge you very low fees, because it can be run passively, I can say, buy on Mondays, sell on Thursdays, this has worked. So I’m going to call buy on Monday, sell on Thursday strategy, and give it a fancy name, saying BOMSOT, which is buy on Monday, sell on Thursday. It’s a BOMSOT Index, and I’m following the BOMSOT Index.

Deepak: Nobody will question you. So the US has gone berserk on this, it is like going to buy that traditional thing about I go to buy a coffee and they say, do you want cappuccino or Americano? I say cappuccino and they say, you want milk, low foam, not this, do you want sugar with that? In the end, dude, I just want a cup of coffee, why do you have all these? But that’s what the US has done, what was supposed to be a simple ETF buy an index, has now become 17000 indexes, so they’ve got something for everybody. So they’ve got leveraged ETFs, inverse ETFs, short ETFs, long ETFs, India ETF, emerging market, developed market, non-US except Canada.

Aditya: There are way more indices than stocks in the world.

Deepak: So we are nowhere there. We have like maybe a few ETFs, most of them chase the Nifty. There are some which are the Nifty Next 50, some mid cap indexes. Some, maybe very few on the fixed income side, there’s a 10 year, G-sec kind of ETFs. The liquid ETFs are horrible, they pay dividend every day, which is just a terrible way to do things according to me. And very few other real bond or fixed income ETFs. There’s some gold ETFs, which for some strange reason underperform by about 2% every year.

Deepak: You’ll remember that ETFs are attractive for multiple other reasons as well. Taxation for instance. When a mutual fund buys and sell in the US, the buy and sell transaction results in a profit at the mutual fund layer. Because in the US mutual funds also don’t pay any tax, the US government, IRS has said, proportion of that same tax that the mutual fund was supposed to have paid, that means the income that was generated by buying and selling in the same year, has to be apportion to every single unit holder and given to him. So if you buy a mutual fund in the US, you will get a receipt saying, listen, I bought so much and sold so much within the same year, and that resulted in this profit. Or I sold so much in this year, and that resulted in so much profit, and that profit is now apportioned to you, so you have 140 dollar gain, or a 5000 dollar gain, some gain, that you have to pay a tax on, this comes to you by say December in the year, or just after December in the year, so you have to pay by March.

Deepak: Now, you’re thinking, listen, I didn’t do anything, I invested in a fund. They bought and sold, or did whatever, now I have to pay tax? That’s what the US funds do, that’s the way that US funds work. But ETFs get this special thing, because ETFs themselves don’t buy and sell stock, what they do is exchange stock for units. So if you give them units, they will give you stock, and if you give them stock, the same stock in proportion they’ll give you units. So technically not buying and selling, they’re issuing units against.

Deepak: So given that, there’s no transaction, there’s no such tax that is applicable inside an ETF. This has resulted in a tax arbitrage as well, some people pump up stocks just before certain events, so that the ETFs get a lot of money in one day, and then all that money vanishes the next day, and nobody has to pay any taxes. It’s a big tax wash scheme that is happening in the US.

Deepak: But because of this, ETFs are phenomenally more popular and financially better for investors. In India, that same rule does not apply. So you don’t have to have similar taxation, because ETFs are not taxed and mutual funds are not taxed. If ETFs generate profits by buying and selling, even if it did that in India, also exchanges blocks in India, but even if it did that in India, it would not pay any tax, and the investor would not pay any tax. So there is no arbitrage to be had in this way.

Deepak: Having said that, I think we have got a bunch of things to do. We need REITs, we need REIT ETFs at that point. We need good fixed income ETFs. We need indexes around a lot of things that currently don’t exist. You’ve got a little bit in the form of consumption, perhaps in the form of public sector enterprises, but I think not enough. Not many international index ETFs. So there’s a Nasdaq ETF, which by the way is probably the best performing mutual fund of India in the last one year, so about 40% yearly returns I think, January to December, but nobody will sell you this because it’s an ETF, and the fund of funds has so little expenses that nobody gets commissions.

Deepak: So there are a few low cost, international investing options available, but not enough. And once we get enough, that time I can say that okay, India will get to 25% or 30% or 50%. I believe that in India we will go down the same way as the US, we will have a hodgepodge of ETFs at some point. One day, we’ll have a podcast about how to select an ETF among the 7500 ETFs that are out there. And people will be like, thank God they came out with this, I was so confused.

Deepak: It’s really a matter of time, but I don’t think we’re there, and I look forward to it. I think Capitalmind as an entity would like to play a part in making that happen, not the confusion, but the clearing of that confusion, and therefore earning some brownie points perhaps. But the point over here is that we’re very early in this whole game, we’re way, way early. It’s just so many good things that are ahead of us, that the more I think about it, the more I think that we are in the cusp of massive change. And as long as the bubble in free money remains, worldwide, including the RBI, I shouldn’t say we’re away from the blame, but because of that, we are likely to see ETFs remain very attractive, and therefore India will have enough time to play catch up.

Aditya: Thanks a lot Deepak. Amazing, thanks a lot for the discussion, and I hope our listeners enjoyed it as well.

Deepak: I sure hope so. I think it’s a time when people wonder what this whole passive market is about, but I hope we gave you some context in building all of this out into a thought process that says, listen I’ll go passive. I would personally prefer a reasonable percentage of more than 50% now I think, perhaps of assets, even my own assets, to be semi passively managed. You may have one active mutual fund and believe that you are actually active, and people are like, no, no, he’s buying HDFC Bank. They’re all herds, they will also buy the same stocks, whose price goes up, and therefore the passive guys follow. Tomorrow the passive guys will come first, and the active guys will follow. There is no difference in thinking that, oh no, no, this is going to collapse one day and all that. Nothing is going to collapse.

Aditya: I also have to save my job, so let’s be closer to the index.

Deepak: Yeah, and it’s perfectly valid incentives. Why do people go to IIT and IIM? Not because they’re the premier education places, I don’t think people who’ve gone and studied in some of the other institutions, the facilities may actually be better, the professors may actually be better. But it’s not about that, it’s the mentality that some of the smartest people in India chose to go there, and therefore as a cohort, people keep thinking those are the only smart people in the country. But it’s not true, a lot of people are not IIT are probably much smarter than the people who are IIT.

Deepak: So there is no reasoning to say that, oh the good people only exist in IIT and IIM. Therefore, there is no reason to say the good fund is only passive, or the good fund is only active. At some point you can say, I am just going to choose to be among the top, rather than the top. And simply because an active fund has fees, has much larger fees, 1-2% a year, you’ll find that over time, it finds it more and more difficult to beat the index. Therefore, the index rises from the average, which would have been 50% of all mutual funds, to around 75% of all mutual funds. So if you want to be among the top 25%, perhaps indexing is for you.

Deepak: I’ll leave you with this. We’d love to hear your thoughts, @deepakshenoy on Twitter, @AstuteAditya on Twitter. And we’re @capitalmind_in, is where you’ll find us, and a lot of our crazy ramblings. is where we have an index strategy that we manage for you with 66% India roughly, 70% top 100 India, 25-30% top 100 US, for as low as 0.25%. I know you can do it yourself, but you listen to this podcast if you were said, listen, you talk so much, I don’t want to spend all this time doing this myself. We do it at a relatively low fee, and it’s been a phenomenal performed in the last one year, thanks to Amazon, Apple and Microsoft.

Deepak: But do consider that as well, that’s my marketing plug for the day. I’ll leave this with Aditya, he’s like you’re talking too much. Thanks so much for listening, and we’re happy to be here.

Aditya: Thanks a lot Deepak.


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