The Birth of Passive Investing

This story begins in the post-war American economic boom of the 1950s. Mutual funds had already become mainstream in the US and were growing at an exceptional pace – returns attracted investments

All funds were “active” at that point – the fund had a defined objective to beat a particular index, and a fund manager (with a team of analysts) attempted to do so by handpicking various stocks & securities. 

The booming stock market naturally sparked a lot of research in this domain, and academics studying the markets had started making some key findings. In 1952, Harry Markowitz’s “Modern Portfolio Theory” introduced the idea of risk-adjusted returns.

Portfolio Theory said that people with similar risk-profiles should hold the same diversified portfolio.

Then came Eugene Fama’s Efficient Market Hypothesis (EMH) in the 1960s, which argued that earning excess returns or outperforming the market isn’t possible in the long-run, effectively because no one consistently has an information advantage. EMH stated that markets are efficient to various degrees (weak, semi-strong, or strong), and stock prices reflected available information/news accordingly – the more efficient the market, and the less the information advantage.

Both Markowitz & Fama later won Nobel Prizes in Economics for their research efforts & findings.

In 1972, Princeton University’s Burton Malkiel published his book “A Random Walk Down Wall Street”, in which he proposed that historical prices have no predictive power. And that investors are “better off buying and holding a diversified portfolio rather than trying to beat the market by purchasing individual stocks or actively managed mutual funds.”

“What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out ‘You can’t buy the averages.’ It’s time the public could.”

Burton Malkiel in his book, A Random Walk Down Wall Street

These various academic findings, combined with the stock market crash of 1973, inspired Jack Bogle to establish The Vanguard Group in 1975. Jack was already a strong believer in passive investing, having studied & written a thesis on the mutual fund industry as an economics student at Princeton University

In 1976, Vanguard launched the world’s first passive index fund called the First Index Investment Trust (now called the Vanguard 500 Index Fund)

Bogle’s fund wasn’t an immediate success, even being called un-American (for advocating average index returns) and being referred to as “Bogle’s folly”. But Jack Bogle persevered with his belief – and the rest is history.

Vanguard is now the 2nd largest AMC in the world, with an AuM of more than $5.5 trillion

Vanguard didn’t just manage to become the largest mutual fund house and the 2nd largest ETF provider in the world – in the process, Jack Bogle created the entire new industry of passive investing, which is why he’s fondly called the “Father of Passive Investing”. Jack passed away in January 2019, but his creation made history later that year in Sep 2019:

“Passive investing styles have been gaining ground on actively managed funds for decades. But in August the investment industry reached one of the biggest milestones in its modern history, as assets in U.S. index-based equity mutual funds and ETFs topped those in active stock funds for the first time.”

“End of Era: Passive Equity Funds Surpass Active in Epic Shift” | Source: Bloomberg

Passive Investing in India

India got its first passive investing options with the launch of the the IDBI Index INit’ 99 Fund in July 1999, shortly followed by the UTI Nifty Index Fund in March 2000. The first ETF in India was created in 2001, when Benchmark Mutual Fund launched the Nifty-50 ETF Fund with a defined objective to track the performance of the Nifty-50 index.

Despite the blockbuster success of passive investing across the globe, the style isn’t yet mainstream in India & has only gained traction in the last few years. The main reasons for this relatively slow adoption are as follows:

• Market Depth & Maturity: financial markets that aren’t mature, like India, tend to have more information asymmetry and inefficiencies that fund managers can exploit. This was one of the main reasons why active investing in India has done well in the last two decades. However, the Indian capital market has undergone major reforms in recent years – SEBI categorisation of MFs, improved guidelines around FPIs/FIIs, improved trading infrastructure, reduction in fees, etc. This has resulted in increased participation from domestic & foreign institutional investors – and as more investors come to the market, it will not only become broader but also more efficient
• Performance of Active Management: active managers in India have been successful in beating the benchmark index for most years in the last 2 decades. Also, even in cases of underperformance, the absolute return has been high enough for most investors to not care about beating an index. After all, when investors get 15-20% net returns, very few even think of how much fees was paid or whether their fund beat the index. But again, this has been changing since 2018
• Commission-based MFs: another reason for the low penetration of passive investing in India is the fact that the mutual fund industry witnesses most of its sales via distributors, who are far less incentivised to promote passive/index funds due to the relatively low commissions associated with them

But things are changing, and passive investing has picked up tremendously, with it’s AuM growing almost 24 times to 1,91,000 crores over the in the last 5 years. Increased awareness & investor education, the underperformance of active mutual funds, and the simple & low-cost approach of passive investing has resulted in an increased demand from retail & institutional investors alike.

With the continuing underperformance of fund managers and a maturing & more efficient stock market, passive investing will only get bigger in all probabilities. If you’re investing in active mutual funds or similar active strategies, or are considering to, I’d urge you to re-assess whether the benefits you’re getting are worth the high costs charged – and if you have doubts, at least read up more about passive investing before you decide. Happy investing!

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Exchange Traded Funds (ETFs) in particular have gained a lot of traction as a way to invest passively at low-costs. If you’re not sure what they are, check out the ETF Education series, starting with ETFs 101 – What is an ETF?