The Indian stock markets seesawed last week between fears of a U.S. recession, the Fed’s three-quarter percentage point rate cut, President Bush’s $150 billion economic stimulus package and a strong show by domestic investors as foreign funds recoiled. The benchmark Bombay Sensitive Index started the week with its second-worst ever intra-day fall of about 7%, but recovered some of that lost ground after Indian finance minister P. Chidambaram issued statements asserting India’s growth fundamentals.

The mayhem, however, threw the spotlight on what has been a striking undercurrent: Passive index funds are gaining popularity as Indian mutual funds, including active funds, grew by 80% to $140 billion (Rs. 556,730 crore) between October 2006 and October 2007. India Knowledge at Wharton spoke with fund managers and faculty from Wharton and the Indian School of Business about the Indian mutual fund industry’s recent growth, and whether active or passive investment vehicles will come out ahead.

Six years ago, when Rajan Mehta left his plush job as vice president at Merrill Lynch in London to co-promote Benchmark Asset Management Co., India’s first asset management firm focused on index funds, he had a tough time convincing distributors and investors of the opportunity in passively managed schemes. He says he felt a vindication of sorts last October, when the Indian edition of Readers Digest recommended index funds.

“Today, our Banking Index Benchmark Exchange Traded Scheme is the single largest equity-dedicated scheme being managed by any asset management company in the India,” says Sanjiv Shah, executive director and Mehta’s co-promoter at Benchmark.

Not-So-Passive Returns

Data on mutual fund returns backs Mehta’s and Shah’s optimism. The average annual return of diversified, open-ended equity funds — which are actively managed — was 47.51% as of last November, according to Value Research, a fund tracking agency in New Delhi. Over the same period, the agency estimates that the average index equity fund delivered a return of 43.52%. The research firm says that in the past two years, passively managed, low-cost index funds returned nearly 46% annually, while their counterparts in active, diversified equity funds averaged close to 45%.

That data has spawned more index funds, and several of them have assets under management of $10 billion or more. The Association of Mutual Funds in India lists a total of 253 equity mutual funds in India, covering active funds, index funds, feeder funds and quantitative-style (or “quant”) funds. Benchmark’s Shah believes that a typical fund manager today manages anywhere between three and 10 schemes, stepping up pressure on performance.

Robert Stambaugh, a Wharton finance professor, says that while it is theoretically impossible for the average active fund to outperform the average index fund, discerning investors would look out for those fund managers who make the most of market imperfections. “If one could figure out which active fund managers are going to outperform [the index], then the market conditions under which they are likely to produce the most returns would be those where the market is inefficient, where prices don’t correctly reflect all available information,” he says.

Premal Mehta, director at Wealth First Advisors, a boutique wealth management advisory firm in Mumbai, says that despite the growing appeal of index funds, he still advises clients to invest in actively managed funds. The distance between the two ends of the performance spectrum can be compelling: Over the past year to January 21, the actively managed Standard Chartered Premier Equity Fund posted a return of 83.14%, while the passive Birla India Opportunities fund fell 3.84%, according to Value Research.

But for every winner, there have to be losers, as Stambaugh points out. “Some active funds can historically outperform the index, but if they do, the other active [fund] managers would have to under perform, because the average [return] would have to come out to be no better than the index [funds’ average],” he says. “So a market where prices are essentially wrong would give the opportunity to the best active managers. But even in that kind of market, the average active manager cannot beat the index.”

Tailoring to Clients’ Needs

The growing popularity of mutual funds in India, including index funds, is evident in the proliferation of schemes and other structured products. These days, investors can choose from asset allocation funds (which invest in different asset classes), passive funds that invest also in other global funds of the same fund house, funds of funds (a scheme that invests in a portfolio of other mutual fund schemes, usually of the same fund house) and multi-manager funds of funds (schemes that seek to identify and invest in the best performing mutual funds).

Vijaya Marisetty, finance professor at the Indian School of Business in Hyderabad, sees in this proliferation the signs of a maturing market. “Index funds are getting a lot of momentum in India. In any market, index funds follow active funds, so their growing popularity in India is a natural evolution,” he says. However, he says index-fund investing in the country is “still at a naïve stage.” He adds: “Not many investors are aware of the index funds concept and few look closely at fund fees.”

Many asset management companies have created new divisions that offer clients portfolio management services (PMS), where they can tailor investments to individual investor needs, unlike with mass market mutual funds. “India is one of the most starved financial markets in the world when it comes to assets one can invest in. Over the last two years, people’s appetite has been whetted by increased wealth and affluence, and they are looking for something edgier in which to invest their savings,” says Shahzad Madon, executive director of ICICI Prudential Asset Management. ICICI Prudential’s assets under management in PMS operations grew from $315 million to $908 million in the past 18 months.

HSBC Asset Management (India), another fund manager, has seen its PMS business grow in the past year by more than $20 million to its current size of $190 million. “Our PMS assets have increased from 4% of our total equity assets under management to around 15% now,” says Sanjay Prakash, the firm’s CEO. He says he expects to build “a billion-dollar PMS business” for HSBC Asset Management in the next three years, “as we see a lot of potential in structured and international products from local investors.”

“Earlier, nine out of 10 investors were unwilling to listen to advice to diversify across markets and asset classes, but today they are more willing to listen,” says Prakash. “As a result, AMCs, too, have graduated from the day when the entire company would focus on one product at a time to a segmentation based on client types, distribution channels and products.”

Saurabh Sonthalia, CEO of AIG Global Asset Management (India), says he is seeing “great demand from retail investors” for schemes that invest in alternate assets such as derivatives, real estate and gold.

Pressure on Fund Managers

With the increased volume in the Indian mutual fund industry, fund managers are facing bigger pressures in stock picking. “It gets tough for fund managers when the nature of the rally is narrow,” says Krishnamurthy Vijayan, CEO of JP Morgan Asset Management India. “Investing in the Indian markets was a no-brainer between 2002 and 2004. Any reasonable stock that you pick and hold could outperform the widely tracked Bombay Stock Exchange Sensex.” The share price of Reliance Industries, for instance, appreciated nearly 215% in the past two years.

“Now is the time when fund management skills come to the fore,” says Vijayan. “Two years ago, to get 20 good investment ideas, you studied 100 stocks. Today, you possibly need to study 200, and that’s where a disciplined process will help managers differentiate themselves.”

Vijayan estimates the JP Morgan team will this year hold 750 to 800 meetings with companies it will consider investing in. Mutual funds in India are barred from investing more than a tenth of any scheme’s assets in one stock, unless they are passively managed index funds or sector specific funds.

At a broader level, some fund managers are critical of the way the indices themselves are constructed. “The benchmark indices such as the BSE Sensex or the BSE 100 and the BSE 200 have an unusual pattern when compared to indices like the Dow Jones Industrial Average,” says Ajit Dayal, founder and director of Quantum Asset Management in Mumbai. “In the Sensex, one to two stocks are changed every year while almost 20% of the BSE 100 and BSE 200 index constituents are changed every year,” he says. Adds Sonthalia: “In developed countries, you don’t have five stocks driving up the benchmark indices.”

HSBC’s Prakash believes “the capitalization is well spread across sectors” in the Indian stock markets. “In Asian markets, the top two industries account for the majority of the market capitalization,” he says. “In India, clearly some sectors have done better than what fund managers had expected, and these relative bets on underweighting or overweighting against the index have helped or hurt performance.”

Potential Impediments

Current investor sentiment across Asia is much too smug for comfort, if you ask Stephen Roach, the Hong Kong-based chairman of Morgan Stanley Asia. “Equity markets in Asia are discounting risks of a U.S. slowdown by believing in the decoupling theory,” he says. “Asia will not be an oasis of prosperity in case of a global slowdown, and the stock market could be hit hard. India is doing terrific but no one can be granted immunity in a global slowdown. India will feel collateral damage in the equity markets.”

Still, fund managers feel there is vast, untapped potential for mutual funds in India. “Household savings in India are an estimated $200 billion, of which less than 5% is invested in mutual funds,” says Sonthalia. Adds Dayal: “The country is getting younger and more people are entering the workforce. As their savings rise, so does their purchase of financial assets.”

Investor preferences between passively managed and active funds appear to be dictated less by their intrinsic appeal than by the marketing tactics of banks and fund managers. “Banks are aggressive in marketing their active funds, and they compare their funds to the historical returns of 40% or more with the 8% on their fixed deposits,” says Marisetty. He sees banks wielding a big advantage here: “Banks have 56% of public savings with them. If banks themselves market the funds, there could be a decent shift [away from bank deposits to mutual funds] in the next few years.”

Benchmark’s Mehta sees distribution as the biggest impediment to the mutual fund industry’s growth. “Many of these alternate products have lower cost structures, and they are unattractive to distributors to peddle,” he says. “As a result, what gets sold often is what’s right for the distributors’ bottom lines.” says Mehta.

Marisetty says he expects active funds to dominate the Indian market for a few more years “until investors get better educated about passive funds.” He says many investors invest in mutual funds assuming that they provide higher returns. “But the concept of mutual funds is to diversify risk, and that is not widely understood in India,” he says.

Marisetty also points to the lack of an independent rating agency like Morningstar in the U.S. There is respite coming on that front with the Indian markets regulator, the Securities and Exchange Board of India, setting up the National Institute for Securities Markets. “We are working to set up something like Morningstar to [form] a central database, to independently assess mutual funds or stocks and disseminate information about them,” says Marisetty, who is on the institute’s visiting faculty.