Do mutual fund costs make a big difference to why investors in India are preferring passive funds over active funds?

Actually costs matter a lot in the choice of passive funds over active funds. But let us spend a moment on how the recent SEBI regulations gave a big push to passive mutual funds. You may recollect that In 2018, SEBI undertook a revamp of mutual fund regulations and one of the key areas was in MF classification. Mutual funds were allowed to have only one category per AMC and each of these categories had to adhere to a strict definition. For example, a large cap fund had to have an exposure of at least 85% to large cap stocks. Mid cap funds had to keep an exposure of minimum 75% to mid cap stocks. SEBI even standardized the definition of large caps, mid caps and small caps by giving them a market cap related interpretation. This largely took away the leeway that funds had enjoyed in the past where they could tweak their holdings in search of alpha. This skimmed away the excess returns that mutual funds offered. Now let us turn to how costs led us to passive funds.

The irony is that nobody bothers about costs in heady bull markets but in tough times, these costs matter a great deal. For example, the median cost (TER) of a regular large cap fund is around 2.45%. Even a direct plan of a large cap fund charges about 1.6% on an average. Compared to that, equity ETF has a TER of just 0.29%. This 200 bps difference between a passive fund and an active fund makes all the difference to the eventual net return. Back in 2016, Warren Buffett in his Berkshire Hathaway annual report had lauded John Bogle as one of the biggest wealth creators for American households. His Vanguard Fund had saved billions of dollars for Americans through index funds and passive funds. It is time for a shift in India too and that shift may have started in the last 2 years.