Part 11 - History of Active Funds and Passive Funds
Part 11 - History of Active Funds and Passive Funds
Below is a concise overview of their development, with a focus on their origins, global growth, and specific trajectory in the Indian context, drawing on general knowledge
Global History of Active and Passive Funds -
Active Funds -
Early Beginnings (18th–19th Century):
The concept of active management predates modern mutual funds, with early investment vehicles like the Dutch "negotiation companies" in the 1700s, where managers pooled money to invest in securities.
The first modern mutual fund, the Massachusetts Investors Trust, was launched in 1924 in the U.S., marking the formal start of active fund management. It aimed to outperform the market through active stock selection by professional managers.
Post-WWII Growth (1940s–1960s):
The Investment Company Act of 1940 in the U.S. regulated mutual funds, boosting investor confidence and leading to a proliferation of actively managed funds.
Active funds became popular as markets grew post-World War II, with managers leveraging research and market timing to seek alpha (excess returns over benchmarks like the Dow Jones Industrial Average).
Peak Popularity (1970s–1980s):
The rise of star fund managers like Peter Lynch (Fidelity Magellan Fund) popularized active funds. Lynch’s fund delivered annualized returns of ~29% from 1977 to 1990, reinforcing the belief that skilled managers could consistently beat the market.
Active funds dominated due to limited alternatives, focusing on stock picking in equities, bonds, and other assets.
Challenges (1990s–2000s):
Studies, like those by S&P (SPIVA reports), began showing that many active funds underperformed their benchmarks after fees, especially in efficient markets like U.S. large-cap stocks.
High expense ratios (often 1%–2%) and inconsistent performance led to scrutiny, paving the way for passive alternatives.
Passive Funds -
Theoretical Foundations (1950s–1960s):
The intellectual roots of passive investing lie in the Efficient Market Hypothesis (EMH), proposed by Eugene Fama in the 1960s, which argued that markets reflect all available information, making it hard to consistently outperform without taking on excessive risk.
Harry Markowitz’s Modern Portfolio Theory (1952) emphasized diversification, supporting the idea of holding broad market indices.
Birth of Index Funds (1970s):
The first passive fund, the Vanguard First Index Investment Trust (now Vanguard 500 Index Fund), was launched by John Bogle in 1976 in the U.S., tracking the S&P 500. It aimed to deliver market returns at minimal cost, with an expense ratio of ~0.5% (later reduced).
Initially met with skepticism (called “Bogle’s Folly”), it gained traction as low fees and consistent returns appealed to investors.
Rise of ETFs (1990s–2000s):
The first Exchange-Traded Fund (ETF), the SPDR S&P 500 ETF (SPY), was launched in 1993 by State Street Global Advisors, offering intraday trading and further reducing costs (expense ratios as low as 0.09%).
ETFs expanded passive investing by providing liquidity and access to niche indices, sectors, and asset classes.
Global Dominance (2010s–Present):
By 2019, passive funds surpassed active funds in AUM in the U.S., driven by low costs (expense ratios as low as 0.03%) and evidence that ~80%–90% of active funds underperformed benchmarks over 10–15 years (per S&P SPIVA reports).
Passive funds grew globally, with major players like Vanguard, BlackRock (iShares), and State Street managing trillions in AUM.
Innovations like thematic ETFs (e.g., clean energy, tech) and smart-beta funds (rule-based indexing) expanded passive investing’s scope.
History of Active and Passive Funds in India
Active Funds in India -
Early Years (1960s–1980s):
The mutual fund industry in India began with the Unit Trust of India (UTI), established in 1963 under the UTI Act. UTI’s Unit Scheme 1964 (US-64) was the first actively managed mutual fund, investing in equities and debt to generate returns for retail investors.
UTI dominated the market, operating as a monopoly with active management focused on stock picking and bond investments, catering to India’s growing middle class.
Liberalization and Growth (1990s):
India’s economic liberalization in 1991 opened the mutual fund industry to private players. In 1993, SEBI (Securities and Exchange Board of India) was established as the regulator, and private mutual funds like Kothari Pioneer (later Franklin Templeton) and foreign players like Morgan Stanley entered.
Active funds proliferated, focusing on equity, debt, and hybrid schemes. They capitalized on India’s fast-growing economy and less efficient markets, where active managers could exploit pricing inefficiencies, especially in small- and mid-cap stocks.
Boom Period (2000s–2010s):
The 2000s saw a surge in active equity funds, driven by India’s stock market growth (Sensex rose from ~3,000 in 1999 to ~20,000 by 2007). Funds like Reliance Growth Fund (now Nippon India Growth Fund) delivered strong returns through active management.
Categories like large-cap, mid-cap, and small-cap funds emerged, with active funds dominating due to the belief that skilled managers could outperform in India’s developing market.
AUM grew significantly, with firms like HDFC Mutual Fund, ICICI Prudential, and SBI Mutual Fund becoming household names.
Challenges (2010s–Present):
SEBI’s 2018 mutual fund re-categorization streamlined fund types, improving transparency but increasing competition among active funds.
Studies, like S&P SPIVA India, showed mixed performance: while small- and mid-cap active funds often outperformed (e.g., 100% of small-cap funds beat benchmarks in some periods), large-cap funds struggled, with ~50%–60% underperforming the Nifty 50 over 3–5 years.
High expense ratios (1%–2%) and manager turnover raised concerns, pushing some investors toward passive options.
Passive Funds in India -
Early Days (2000s):
Passive investing in India began with the launch of the first index fund, the UTI Nifty Index Fund, in 2000, tracking the Nifty 50. It aimed to provide low-cost exposure to India’s top companies.
The first ETF, the Nifty BeES (Benchmark Exchange Traded Scheme), was launched in 2001 by Benchmark Asset Management, tracking the Nifty 50. It introduced intraday trading on the NSE.
Slow Adoption (2000s–2010s):
Passive funds initially saw low traction due to India’s preference for active management, driven by the belief that skilled managers could outperform in a less efficient market.
Limited awareness, fewer index options, and low ETF liquidity (due to low trading volumes) hindered growth. By 2010, passive funds accounted for a small fraction of mutual fund AUM.
Growth Spurt (2010s–Present):
The 2010s marked a turning point, driven by:
SEBI Regulations: SEBI capped ETF expense ratios at 1% and encouraged low-cost passive products, enhancing affordability.
Government Initiatives: The Employees’ Provident Fund Organisation (EPFO) began investing in ETFs like SBI ETF Nifty 50 in 2015, boosting AUM.
New Offerings: Funds like Bharat Bond ETF (2020) and thematic ETFs (e.g., Nifty Tourism Index) expanded options.
Rising Awareness: Investors recognized the cost benefits of passive funds, especially in large-cap segments where active funds struggled to beat benchmarks.
AUM for passive funds grew significantly, from ₹25,000 crore in 2019 to over ₹1 lakh crore by 2022, with a 4x increase in overall passive AUM from January 2019 to February 2022. Equity ETFs saw 100x AUM growth, and debt ETFs grew 39x in the same period.
In 2024, 63 new passive fund offerings were launched (vs. 51 in 2023), reflecting growing demand.
Current Landscape (2025):
Passive funds now include index funds and ETFs tracking indices like Nifty 50, Sensex, Nifty Next 50, and total market indices (e.g., Nifty Total Market Index with 750 stocks).
Major players include SBI Mutual Fund (SBI ETF Nifty 50, ₹81,194 crore AUM), HDFC Mutual Fund (HDFC Sensex ETF, TER 0.05%), and Nippon India (Nippon India ETF Nifty BeES).
Passive funds are gaining popularity for their low costs (TERs as low as 0.03%–0.5%), transparency, and suitability for long-term investors. However, they remain a smaller share of India’s mutual fund AUM (~10%–15%) compared to active funds.
Key Milestones in India
1963:
UTI launches India’s first mutual fund (active), US-64.
1993:
SEBI regulates mutual funds, allowing private players; active funds dominate.
2000:
First index fund (UTI Nifty Index Fund) marks the start of passive investing.
2001:
Nifty BeES, India’s first ETF, is launched.
2015:
EPFO begins investing in ETFs, boosting passive fund AUM.
2018:
SEBI’s mutual fund re-categorization enhances transparency for both active and passive funds.
2020s:
Rapid growth in passive funds, with new ETFs and index funds targeting diverse indices.
India-Specific Dynamics -
Market Efficiency:
India’s markets, particularly small- and mid-caps, are less efficient than developed markets, giving active funds an edge in generating alpha. However, large-cap segments are increasingly efficient, favoring passive funds.
Investor Behavior:
Indian investors historically favored active funds due to a cultural belief in “mental labor” for returns and the potential for high gains in a growing economy. Passive funds are now gaining traction among cost-conscious and younger investors.
Regulatory Support:
SEBI’s push for low-cost products and transparency has accelerated passive fund adoption, while capping expense ratios ensures fairness.
Performance:
Active funds excel in small- and mid-cap categories, but passive funds are more competitive in large-caps, where ~60% of active funds underperform the Nifty 50 over 3–5 years.
AUM Trends:
Active funds still dominate AUM (~85%–90% of mutual fund AUM), but passive funds are growing faster, driven by ETFs and institutional investments.
Conclusion -
Globally, active funds emerged first, dominating until the 1970s when passive funds, starting with Vanguard’s index fund, offered a low-cost alternative.
In India, active funds led since the 1960s with UTI, capitalizing on market inefficiencies, while passive funds started in 2000 with index funds and ETFs, gaining momentum post-2015 due to regulatory support and cost advantages.
Active funds remain popular in India for their potential to outperform in small- and mid-cap segments, but passive funds are catching up, especially in large-caps, with AUM growth and new offerings.
The choice between active and passive funds in India depends on investment goals, risk appetite, and market segment, with a hybrid approach often recommended.
