Passive funds have been big beneficiaries of the record inflows into mutual funds since Covid market lows. This category accounted for about 16.5 per cent of the assets managed by the industry in May 2024, more than double the 7 per cent share four years ago. In developed markets such as the US, passive funds have already nudged past actively managed funds. Considering cheaper costs and the lower risk associated with these funds, the Securities and Exchange Board of India’s (SEBI’s) move to frame ‘MF Lite’ regulations to encourage passive products is a step in the right direction.

A nudge towards passive products is good for mutual fund investors on many counts. For one, with over 30 categories of actively managed products on every AMC’s (Asset Management Company’s) menu, investors who are new to mutual funds are often befuddled by a problem of plenty and are unable to make informed choices on the right categories or fund managers to select. Passive funds narrow down the choices as they mirror known indices. They also shield investors from excessive dependence on fund manager skills and the success or failure of a fund house’s investment style or thesis. Passive funds are also an option for investors with lower risk appetites, as the downside is capped to the extent of the fall in the index when market conditions turn hostile.

More importantly, active funds in India are finding it a tough task to beat their benchmarks. A paper put out by SEBI last year showed that be they direct or regular plans, only 27-66 per cent of the active funds were able to match or outperform their benchmarks over 1 to 10-year timeframes. Passive funds are already far cheaper for investors to own than active funds. While index funds and exchange traded funds charge a maximum TER (total expense ratio) of 1 per cent, TERs on active funds can go as high as 2.25 per cent. While SEBI has been grappling with the issue of trying to reduce TER caps for active managers, encouraging more passive funds may be a simpler way to achieve such reductions through competition. The entry of more AMCs into the field, enabled by lower net worth requirements under MF Lite could aid competition and benefit investors too. Existing AMCs — who can hive off their passive schemes under MF Lite — may also be able to rejig their cost structures.

That said, a few aspects of the MF Lite regulations need fine-tuning. The regulations seek to introduce a new category of hybrid passive funds, but try to micromanage how exactly these indices should be constituted. This could stifle innovation as the risk appetite of investors seeking hybrid funds can also vary. While existing AMCs are allowed to hive off their passive business, separating shared resources may be easier said than done. The move to encourage passive products must also go with fostering further innovation in index construction itself, currently vested with the exchanges. SEBI should also go for uniform applicability of MF Lite across all passive schemes.

Related Topics