For price-conscious investors, ETFs may be a better fit than index funds, says Pratik Oswal of Motilal Oswal AMC (2024)

The argument that large passive flows don’t allow for an efficient price discovery is a bogus theory since the biggest segment in the market is not passive but equity shareholders, Pratik Oswal, President, Passive Funds, Motilal Oswal AMC tells ET Wealth's Sanket Dhanorkar.

A chunk of large-cap flows now goes into passive strategies. Even non-EPFO flows are higher. Is this shift a structural story?
The non-EPFO flows into passive large-cap funds is surprising. This is definitely a trend. Most advisers and wealth managers have also taken the stance that when you play the passives, it has to be in large caps. This is where the efficiency is the highest. Obviously, stock picking is relatively harder in the large-cap space. Most of the passive flows are in large caps, not just in India, but globally as well.

Some market commentators argue that unrestricted passive flows can distort the market. What’s your take on this?

The argument that large passive flows don’t allow for an efficient price discovery is a bogus theory, simply because the biggest segment in the market is not passive, but equity shareholders. If you take the market cap of Google, or Microsoft, or Apple, the majority will be held by individual shareholders, institutions, pension funds and family offices. Mutual fund is just a vehicle. Even if 55-60% of the market is passive in mutual funds, that is still less than 20% of the overall ownership of these stocks. The majority of holdings tend to lie with individual shareholders and active traders, which ensures that price discovery is taking place efficiently. To that extent, the argument does not hold.

Passive funds now cover the entire spectrum of market caps, sectors and themes. What more innovation can we expect in this space?
There has been a lot of innovation in passives in multiple asset classes, including debt funds, international funds, even multi-asset funds. Five years ago, we only had the Nifty and Nifty Next 50 index funds. There is still a lot of scope for innovation. We may soon see passive hybrid funds, depending on how regulations go. A lot more categories can be created in passives. In the US, for example, the biggest innovation has been active exchange-traded funds (ETFs).

Passive funds carved a distinct identity within debt funds via the target maturity funds. Do you think tax changes could kill this space?
With target maturity funds, a big factor was lower cost, but the bigger one was taxes. It was basically like a fixed deposit product with mutual fund debt taxation (in earlier form). This tax arbitrage was one of the reasons such funds did very well. Unfortunately, that has gone now. The segment has slowed down after this change. Now, fixed income is basically the same within mutual funds as it is outside. However, there is always a big appetite for fixed income in India. We will see a lot more innovation in the passive debt space. Indexing in fixed income is a little more challenging in terms of replication. Sebi has already put in place regulations in fixed income, which has made it easier for AMCs to manage this space on scale.

Passive strategies now form more than 50% of international funds’ AUM. How will tax changes and limits on overseas investments affect this segment?

The limit on overseas equity investments has surely been a big drawback. The ETF route is still open, but that also has limited space. It has been a setback for anyone looking to invest overseas. Taxation is also slightly unfavourable now. However, this segment is huge and it is an important part of the portfolio. Passive is the right way to buy international stocks. It’s low cost, transparent and easy. Hopefully, we will see some change in the limits soon.

Have you observed any divergence in holding periods between active and passive funds?
Our own funds have not been around for a very long time to comment on holding periods. However, in general, the flows tend to be very performance-driven in active funds, whereas in passives, there is no underperformance or outperformance. So, when you’re buying a passive fund, you either invest for a long time, or you buy for a very short term, trying to time the market. Our experience tells us that most people who invest in passive funds are looking at it from an investment point of view. So, we have not seen a lot of churn in our passive funds.

Last year, Sebi introduced new rules around market making in ETFs. Has liquidity materially improved beyond the bigger ETFs?
The new regulations have certainly helped. The hike in the minimum basket size to Rs 25 crore for selling units directly to the AMC has ensured that investors approach the exchange, not the AMC. The volumes on the exchanges have increased since last year, at least for the top few ETFs. It is still far from the ideal situation. The impact cost is very high. Liquidity is not great for anyone looking to buy big quantities. So, it is going to take some time for the industry to evolve.

Do you recommend investors to opt for index funds over ETFs?
Investors should choose whatever is convenient to them or whichever experience suits them. If you’re agnostic, we would recommend index funds. These have obvious advantages. You don’t have to worry about impact cost and liquidity. You can set up SIPs. No demat account is required. However, if you want to buy at a specific time of the day, then ETFs might be helpful. If you are price conscious intra-day investor, ETFs might be a better fit. For most investors, index funds offer a lot more simplicity.

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