Dependence: Is overreliance on passive investing good for the market?

ETFs have recently been in operation in India. The Indian ETF class as reported by NSE received inflows of Rs 1.28 crore in FY 21-22. Total AUMs of passive funds in India which include ETFs and ETFs are now nearly INR 5 crore. Although it appeared in India in 2001, ETFs have only recently gained popularity in India and passive investing is now being promoted as an obvious way to invest in stocks.

In times when the markets are sideways or in a downtrend, it is seen that ETFs can generate slightly better returns than their actively managed counterparts, due to the 1-1.5 percent difference in the expense ratio.

Passive money is also beneficial because it is free from any risks related to stock selection; They iterate over the index that is being tracked. Innovation is also put to work in passive investing and there are smart pilot funds or working mutual funds that add a dimension of active investing within passive investing by creating funds based on momentum, value or volatility, driving investor interest.

This collective rise of negative chests also created one challenge. Due to the growing interest in investing in passive funds, price elasticities and demand are now affected. Stock prices are governed by two main factors: the fundamentals of the business and the interest of market participants in buying or selling. A surge in inflows into ETFs and ETFs distorts market efficiency as passive funds don’t buy less when stock prices are high or invest more when prices are low. For example, in India, EPFO ​​currently manages around Rs 15 crore and the number is constantly increasing due to the monthly influx of subscribers. It has a policy of investing 15 percent of its monthly flows in the stock markets through a couple of passive funds. Hence, regardless of prices, EPFO ​​demand remains inelastic.

The constitution of the index is another aspect to focus on. The main criteria are price performance, market value and liquidity or free-floating. So, basically, any stock that does very well in price parlance is added to the index, and the poorly performing stocks are eliminated. Hence, all passive strategies that follow that index have to rebalance their funds by buying already high stocks, which increases the stock price, thus reducing market efficiency.

Liquidity is another aspect of any market-driven instrument and it also applies to ETFs. While the inflows and the number of investors investing in these funds has increased significantly, ETFs are still not highly liquid instruments. There have been many cases where ETFs have traded much higher or lower in the markets compared to their NAV. Although liquidity is an issue with ETFs in India, it is fleeting, and the solution to fix this is the growth of the ETF market itself.

Government and regulators have been driving the growth of ETFs, in addition to the contribution of EPFO, the introduction of ETFs such as the Bharat -22 ETF, a CPSE secondary subscription round, along with the Public Service Bank (PSB) ETF has added to the growth of the market. ETF. The organizers also did their part; One example could be the creation of special market makers called Accredited Participants (Aps), which arrange the required liquidity.

So far it seems that although passive investing is beneficial to investors, is it also beneficial to the market as a whole? Take the example of the United States, here the volume of ETFs has reached a level where ETF investments affect foreign emerging economies around the world. This is also a potential risk for them, as mass selling of ETFs could have serious economic consequences for these markets. The conditions that allowed the growth of ETFs in the United States were many and varied.

In 2008, mutual funds in the United States had very high amounts of entry fees, combined with a fixed high minimum entry price. The front-loading fee for mutual funds may be as high as 4.5 percent at that time. This was the cost of putting your money in the hands of an expert investor. While in India, the play is different, here ETFs allow Indian savings in the right direction. Its market here is not deep enough to have a negative economic impact.

On the cost side too, most ETFs don’t offer significant savings when compared to their high-performing active counterparts, so investors are sure to consider both mutual funds and ETFs while creating their portfolios.

(The author is the director and co-founder of Valtrust. Recommendations, suggestions, opinions and opinions provided by this expert are his own. These do not represent the views of the Economic Times)

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