The amount of money being poured into index funds is escalating at burgeoning rate in developed economies. As per analytical studies 40% of money in U.S stock funds is in index funds. One of the first index funds was launched in United States in 1975 by John Bogle to track S&P 500. It was initially ridiculed but now has been very successful and is famously called Vanguard 500 index. Investments in high cost actively managed fund are plunging since a quite long time now. Conversely, in emerging markets like India index funds aren’t very popular.
Active funds involves high expense ratio of almost nearer to 0.84% and are expected to beat the benchmark returns. High expense ratio is on account of research, analysis and frequent trading of stocks. However in developed economies, fund managers haven’t been successful in beating the benchmark returns. Over the 32 years, actively managed funds trailed their benchmarks by an average of one percentage point a year. If a benchmark like the Standard & Poor’s 500 returned 10%, the average managed fund investing in similar stocks would therefore have returned 9%. The markets in west are deep and highly developed so stock pickers aren’t able to find mispricing and benefit from them. Thus the underperformance of actively managed funds has caused the shift towards index funds. Capital market in emerging economies isn’t as developed and structured as of west so there are high chances of price discrepancies (undervaluation and overvaluation of stocks) so stock pickers are able to find undervalued stocks and benefit from owning them. Therefore, investors in these economies are attracted towards active funds regardless of higher fees as outlay would easily get covered by returns.
The other aspects which I would like to discuss are that emerging markets aren’t able to offer index funds at lower expense ratio. There is marginal difference between expense ratios of actively and passively managed funds which doesn’t incentivize investor to go for index funds. The tracking error in BRICS context is higher as a result of poorly constructed indices and difficulty involved in tracking them. Index funds work very well in markets which are having free flow of information. All the information that may affect stock price is already factored in, so there are fewer chances to gain beyond them. However in emerging markets there is disrupted flow of information especially in small and mid-cap segment.
Therefore main benefits of investing in index funds which is low expense ratio and better returns than actively managed funds is more or less absent in emerging markets. The people who want benefit of passive investing do so by creating SIP in an active mutual fund. While organized capital market in advanced economies leads investor to pour their money into index funds and as a result of which Vanguard 500 (largest provider of index based mutual funds) has become largest investment management company in world.