What are passive funds in India and why are people investing in this new category of funds nowadays?

You are absolutely right; passive Funds in India are going great guns. Now passive funds are unlike the typical equity funds where fund managers take decisions decide what stocks to buy and what to sell. Passive funds just tag themselves to an index like Nifty or Sensex and try to mirror the index as closely as possible. Since the effort is less the cost is also less and that lower cost gets passed on to the investors. That is how simple passive funds are.

Let us look at the flows. Index funds and index ETFs saw flows of Rs.6,000 crore in October almost equal to the total flows of all equity oriented active funds. But that is not all. In the last five years, the AUM of passive index funds in India has moved up sharply from Rs.3,500 crore to Rs.1,85,000 crore and this figure promises to only grow further. The AUM of passive index funds in India is just about 6% of the total AUM compared to 35% in the US, but the shift has surely begun. You need to understand why these index funds are attractive and what has changed in the recent past.

One basic rule is that these passive funds like index funds and index ETFs do very well when the market becomes highly volatile and unpredictable. Actually, it is not just volatility but how the returns are getting concentrated in just a handful of stocks. For example, if you leave out TCS, RIL, HDFC Bank, ICICI Bank and HUVR, then the Nifty would have actually under-performed in the last one year. Active funds cannot concentrate their portfolio in a handful of stocks as it goes against the basic grain of diversification. The moment they have spread their holdings in this market, these active funds have underperformed. You just need to look at the numbers. In 2019, active funds earned a median return of 5.3% against 9.3% for the passive funds. In the year 2018, active funds had given negative returns while funds had yielded positive returns of 2.3%. This differential is driving money towards passive funds. In short, out of the top 200, just about 10-15 stocks are doing extremely well and the rest are laggards. That is why active funds are getting badly hit.