Index funds have come a long way in the investment landscape. The first index fund was launched in the 1970s and despite less traction in the first few decades, it’s now changing the industry landscape globally.

In countries such as the US and other mature markets, most incremental equity flows are going into index funds and ETFs.

Ten years ago, passive funds in the US comprised 10 per cent of the overall mutual fund equity assets. Today, it’s well over 50 per cent. Fund managers are finding it harder and harder to beat broader benchmarks, especially with bulging assets. As a result, investors are seeking safety and consistency in simple broad market index funds.

But this is about the mature markets. Will India see a similar turn of events?

Instead of focusing on the reasons why history will repeat itself, let’s talk about the reasons why history won’t repeat in India.

Mutual funds are still a sold product

Mutual funds are an intermediary driven business in India, whereas in the mature markets, commissions are close to zero and advisors charge the customer for advice.

With little to no embedded commissions in index products, there’s a lack of incentive to promote index funds. With investing in direct plans becoming increasingly popular, index funds are slowly becoming better placed than they used to be.

India has a long road ahead with low equity penetration levels. Therefore, mutual funds are expected to be sold products in the near future.

With an increase in direct investment and more fee-only advisors, index funds are expected to grow in a big way.

India: still return driven

Index funds rarely make it to the top mutual funds sorted by returns. History says that top funds rarely stay at the top. Also, it’s easy to recommend funds that are high performers in the past.

Investors in India are looking to maximise returns without understanding risk, while in the mature markets, it’s all about risk-adjusted return.

Index funds, as a result, have proven to be better and consistent when accounted for risk. An investor selecting a large-cap index fund can expect it to be less risky than a mid-cap index fund, whereas this is not clear with active funds. Investors today have started to talk about risk but it’s still at a very nascent stage.

Benjamin Graham has said, “The essence of investment management is the management of risk, not the management of returns.” Returns, as investors have witnessed in India, are volatile and hard to predict.

Fund selection over asset allocation

Investors today have moved from stock pickers to mutual fund pickers. Finding the right mutual fund across multiple categories and fund houses can be challenging with performance being inconsistent across long-term horizons. With index funds, this is simpler.

Asset allocation is becoming the right way forward as various studies have shown that more than 90 per cent of the long-term portfolio performance depends on asset allocation and not fund selection. What that means is that what an investor buys or sells or churns does not matter. What matters is the combination of funds.

Mature markets have adopted asset allocation well and, as a result, have chosen index funds. It’s still early days for asset allocation in India but will ultimately drive inflows into index funds.

The explosion in alternative products

Even though active investing has come down dramatically in the US, alternatives have exploded. Active investing has left the mutual fund industry and is now dominant in the alternative space (for example, hedge funds, solutions, wrappers).

Just like in the West, alternatives in India are set to grow too. Index funds are simple products and hard to offer in the form of an AIF or a PMS. With many advisors increasing focus on the alternative space in India, index funds will not be as easily available.

Alpha not well understood

Education in the financial services industry is still low at the average customer level. As a result, the biggest obstacle for index funds today is education and awareness.

When Motilal Oswal AMC launched India’s first smart beta fund in 2010, many customers didn’t understand the product. Customers called asking about the fund manager and the stock selection criteria. It was hard to explain the quant brain behind the stock selection and that no real person was behind the stock picks.

Even today explaining a pure broad index fund (market-cap-weighted) is not easy. Hence, it will take time for a customer to get well acquainted with index funds.

Alpha itself is an obscure concept for the average investor. Apart from the asset management industry, which includes AMCs, distributors, advisors and a small proportion of well-read investors, the concept of alpha and beta is either misunderstood or not understood.

An average investor also fails to look at relative returns and only cares for the absolute figure. As opportunities to deliver alpha shrink with time in India, relative performance is key in adopting index funds in a portfolio.

The points above explain the differences between the investing ecosystem and customer mindset in India and other mature markets.

It’s also important to realise that with expected changes in the ecosystem and incentive structures, these differences will narrow over time. And when that happens, investor holdings will have more of index funds.

How long will that take? It isn’t very easy to say.

The writer is head of passive funds business, Motilal Oswal AMC