Monday, May 04, 2009


(May 2009)
Index Funds
The slow but sure tortoise…

The active versus passive debate in investing started almost 50 years ago when the Efficient Markets Hypothesis (EMH) was unveiled. The more efficient the market, the more difficult it is to generate returns in excess of a broad index. The passive investor who believes in EMH ensures the default market return by investing in the index over the long term to smoothen volatility. The active investor tries to beat the market by creating a stock portfolio and timing entries and exits to coincide with ups and downs. It is tempting to be active because no market is perfectly efficient. There will always be imperfections that a smart investor may exploit. But few people beat the market and even fewer do it consistently. That evidence is strongly in favour of the EMH. When it comes to mutual funds, the entire class of index funds was created with passive investors in mind. This tortoise of the mutual fund industry is slow but sure.

Mirroring the index…

The mandate for an index fund is simple: mirror the index. The fund manager has to own index stocks in exactly the same ratios as their weights in the index. If there is a change in the index population or in weights, the fund must rebalance. Stock indices are either un-weighted or weighted according to some formula of market capitalisation. Whatever the formula, rebalancing weights of an index fund with no change in population, is a mechanical task of maintaining even-number ratios. It is more delicate if there is a split or a new company is inducted.

Key Measures of Performance

Index fund investors need to look at three key measures of fund performance. One is low-cost. The second is liquidity. The third is the deviation of the index fund's return from the actual index return. The first and second measures are driven by competition. So an index fund must have low-load and low expense ratio. Since there are many competing index funds, they all offer reasonable liquidity and reasonable expenses. The third measure is the ‘tracking error’ (TE) and this must be minimised. An ideal index fund would offer zero tracking error and mirror index return exactly. While this is obviously impossible, a good index fund will keep TE below 0.5%. Tracking errors are understandable when there are big changes in index population. They are also normal in the first few months of an NFO. They can also be caused by a scenario of massive redemptions or by an influx of cash if new units are being issued.

Benchmark is the only Indian AMC that is totally focussed on passive investing. It offers index ETFs that have TEs of less than 0.5%. Among the other AMCs, many have month-on-month TEs of over 3% and very few have stayed under the 0.5% threshold. Errors of 2-3% level cannot be brushed aside in view of the compounding effect and the fact that index fund investors are generally long-term players. For example, an investor with a 3% annual TE and a 3-year investment timeframe may see absolute return deviate by 15% from the index return. Why has this happened with well-established fund houses? We see two persistent problems with portfolios of high TE funds. The first is that there are some differences in their portfolio-weights, compared to the index-weights. The second is a higher level of cash assets than desirable. The portfolios weights are generally not very different from the index weights. But even small changes can cause relatively large TE. The second cause for deviation is easier to understand. Apart from Birla Sun Life, which has a massive 25% in cash, there are several others (ICICI and Magnum) with double-digit cash. Most index funds hold around 3% in cash. For an open-ended fund, this is not an unusual cash-level because of redemption contingencies as well as possible inflows from the issue of new units. But even 3% cash seems enough to guarantee significant TE. The Benchmark schemes generally have between 0.5-1.5% of assets in cash and they appear to have gained from a structural advantage of ETFs over open-ended funds. Benchmark offers the only ETFs, while the other index funds are all open-ended. ETFs need not worry about cash redemption. Units are traded on the exchange and if at all, units are extinguished, underlying shares are offered in exchange, rather than cash.

One up on Diversified Equity Funds…

The steep decline in the equity market in 2008 has wiped out a large part of investors’ wealth, irrespective of whether they took the direct investment route or went through mutual funds. In a volatile market such as the present one, predicting short-term movements and timing the market, despite the steep corrections already witnessed, remains a challenge. In uncertain times investing through index funds may be a better option if one prefers to go with the market tide. The one-year return clocked by the index funds is between -41.5 and - 47.5 per cent, as against BSE Sensex and S&P Nifty decline of 54.7 per cent and 54.3 per cent respectively. The divergence between the benchmark performance and the index funds is due to tweaking of the portfolio with minor changes in the weight of stocks held and cash position of the funds. During the same period diversified funds have declined in the range of 34-74 per cent.

…and its more aggressive cousin – Sector Funds

Most sector-based mutual fund schemes have fared worse than their index counterparts during the past six months. These funds might have performed worse than their corresponding indices as they are more diversified. Moreover, stock selection might not have been that prudent enough in some cases. On an average, the category returns of banking sector funds have been a negative 30 per cent in six months, while the BSE-Bankex fell by around 16 per cent during the same period. In the case of technology-based funds, the category average was a negative return of almost 42 per cent, while BSE-TEC and BSE-IT had fallen 33 per cent and 34 per cent, respectively. The funds investing largely in the FMCG space have on an average given negative returns of more than 27 per cent, while the BSE-FMCG index has fallen by 13 per cent. The category average return of auto funds has been a negative 35 per cent, while the BSE-Auto has fallen by 33 per cent. The only sector-based funds that seemed to have outperformed their index counterparts are pharma funds, with category average returns of around negative 24 per cent, while the BSE-Healthcare index fell by more than 30 per cent.

In the long run…Index Funds prevail

In India, we have index funds that track either the S&P CNX Nifty or the BSE Sensex. Both are large cap indices and therefore, by default, the index funds tracking them are ‘large cap’ funds. Investors, looking to invest in quality stocks across the leading sectors, can take a medium to long-term view and patiently ride through the market gyrations by investing in index funds. Actively managed funds may do better than indices for a short while, but in the long run, the indices will overpower them. Fortunately, the study of long-term investment performance is not one of those areas where one has to go by anecdotes or opinions. It is a field uniquely suited to hard numbers, the harder the better. And here are some of the hardest one can find about this matter. There are 60 actively managed diversified equity mutual funds in India that have existed for five years or more. If one were to add the Sensex and the Nifty to these 60 and rank the resulting list for five-year investment performance, one will find that the Sensex is ranked 50 out of 62 and the Nifty 58 out of 62. It is true that if you take a shorter period, say, one year, you will find the Sensex and the Nifty doing better with the Sensex ranked at 101 out of 169 and the Nifty 87 out of 163 but that is better only compared to their longer-term performance.

No matter how detailed a look one takes at the numbers, the truth is that there are odd periods when the indices do better but most of the time, most active funds beat them handily. This is actually the opposite of what indexing fans would have one believe. However, one is by no means wedded to the idea of active management. In fact, one happens to think that fund management standards in India are declining and eventually, the indices will start doing better than the average (but not the better) funds. But when that day comes, there will not be any need for debates and opinions, hard numbers will prove it beyond doubt.

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