Monday, May 31, 2010

May 2010

Piquant parade

Private sector mutual fund, Axis Mutual Fund, is aiming at more than doubling the size of assets under its management to Rs 10,000 crore and investor base to 30 lakhs by March 2011 and is looking at entering the overseas markets in 2012. Axis Mutual Fund currently has a distribution centre in Dubai. Axis, which got SEBI approval for mutual fund business in September, 2009, currently has an AUM of around Rs 4,000 crore. The fund currently has an equity base of Rs 75 crore, which could be raised to about Rs 125 crore in two years. Axis Mutual Fund is looking at becoming one of the top 10 players in the next 4-5 years. By then, the mutual fund industry is expected to grow over three-fold to about Rs 25 lakh crore.

An MOU was signed between Birla Sun Life Mutual Fund and Oriental Bank of Commerce for a strategic alliance to distribute and market mutual fund products through branches of Oriental Bank of Commerce. The bank is committed to become a financial supermarket that provides diverse financial products under one roof to its customers.

Regulatory Rigmarole

Association of Mutual Funds in India (AMFI) has announced that distributors will not get trail commission in case the investor transfers his mutual fund account. The unpaid trail commission will be put in an investor education fund. Asset Management Company pays trail commission to the distributor if the investor stays with a mutual fund scheme. Securities and Exchange Board of India (SEBI) had earlier allowed investors to change distributors without No Objection Certificate from the current distributor; this had led to a sharp rise in the transfer of accounts. As per the new guideline, AMC will not pay trail commission to either the old or the new distributor if the mutual fund account is transferred.

The Securities and Exchange Board of India has directed asset management companies to disclose investor complaints. Investor complaints will have to be disclosed on websites and annual reports. AMCs will have to upload 2009-10 data by June 30, 2010. Going forward, they will have to disclose details after two months of the closure of the financial year.

Self-styled distributors, lacking basic qualifications to sell mutual fund units, are advising investors as to where they should put their hard-earned money. Distributors need to pass the AMFI Advisors’ Module if they want to sell mutual fund schemes to investors. Top national distributors, who sell investment products across asset classes, are not insisting on AMFI certification while appointing sub-brokers (sub-advisors or franchisees). This is more prevalent in franchisees or sub-broker offices in tier-II and tier-III cities. Top distributors simply ask for a small membership fee at the time of empanelling as a sub-broker. They are not really concerned about AMFI registration or any certification. These distributors are allowed to sell products across asset classes, from equity mutual funds to ULIPs, corporate deposits and even Nabard bonds on certain occasions. While fund houses are aware of this trend, they are not really worried about it. According to them, AMFI advisors’ module syllabus is outdated —the syllabus was last updated in mid-2006 — and could be slightly out of context, considering the large number of changes effected to the mutual fund industry post-2008.

In a month’s time, short-term debt mutual funds, which make up an overwhelming proportion of the Indian mutual fund industry, will undergo a fundamental change. These products are the staple of corporate investments that are made in mutual funds. They are the most popular asset class into which Indian CFOs park short-term cash in order to generate safe and predictable returns. The predictability of the returns is a key reason as to why these products are used. However, under the new valuation rules that SEBI has implemented, these funds are going to be a lot less predictable from July 1, 2010. The reason for this change is that the daily valuation of these funds are going to be done on the basis of the market price of their investments, rather than a straight-line value calculated from their coupon rate, as has been the practice so far. Investors can invest in them even for the shortest periods and know precisely how much they can expect the NAV to be each day in the future. Moreover, unlike bank deposits, it has so far been practical to make and redeem investments in these funds even for extremely short periods like two or three days. Now, all this is set to change.

Around Rs 120-150 crore of distributor commission is yet to be released by fund houses, citing non-compliance with the latest SEBI rules on know-your-client (KYC). Foreign banks, which are among the largest mutual fund distributors, have been hit the hardest. That is because these banks, which follow a calendar accounting year, have already factored in the earnings from mutual fund distribution in their international balance sheet. They will now either have to provide for this amount, or declare it as disputed income in their audited results. Most of the Indian private sector banks have not accounted for it last year (financial year 2009-10). They still have some time to account for it. However, the foreign banks have a different reporting system. After domestic private sector banks, foreign banks are the largest distributors of mutual fund products in the country. These include Citi, HSBC, Standard Chartered Bank, Deutsche Bank, BoA Merrill Lynch, ABN Amro (now RBS) among others.

Market regulator SEBI released panel report by various industry subgroups recommending changes to the eligibility and networth criteria for market intermediaries. It has recommended that the net worth for asset management companies should be increased to Rs 50 crore over a period of three years in a phased manner from the current limit of Rs 10 crore. Increasing the net worth requirement will not do anything tangible to increase investor safety. However, it will definitely increase entry barriers in a field that needs more competition. Moreover, monetary penalties should be imposed on AMCs who inadequately disclose their scheme holdings.

SEBI is preparing ground for a fresh set of mutual fund reforms to make the instrument more transparent and attractive for investors. The Mutual Fund Advisory Committee, comprising industry and SEBI representatives want fund houses to keep promotional expenses, such as those on foreign trips and gifts to distributors, outside the ambit of the expense ratio. This ratio — it includes fees paid to fund managers, advertising, legal, record-keeping and accounting costs, custodial charges and taxes — is capped at six per cent for a scheme. In most cases, fund houses keep the expense ratio around 2.5 per cent, but include promotional costs in the calculation. The regulator suspected that many costs passed off as advertising or promotional expenses were in reality paid to distributors for pushing sales.

The regulator would want to put in place a more investor-friendly performance review mechanism. At present, apart from the daily net asset value, fund houses put out monthly fact-sheets which provide mathematical calculations comparing and evaluating the schemes on offer. The regulator feels retail investors find this form of review complicated. Instead, it wants mutual funds to provide specific quantitative parameters for one to be able to judge the performance of a scheme.

The advisory committee is also to discuss issues like guidelines for mutual fund investments in equity derivatives. This has become a contentious issue. Some members feel fund houses should not be allowed to invest in risky instruments like stock derivatives. However, if a complete ban was not possible, there should be some specific guidelines.

The committee was also likely to look at the issue of conflict of interest among trustees, asset management companies, and managements of fund houses. SEBI had addressed the issue by ordering that AMCs, trustees, and managements should have different sets of individuals.

The continuous stream flowing out of the regulator's kitty bears testimony to the fact that the regulator wants to ensure that no gaps remained in the regulations.

It is vacation time! In the ensuing three months, FUND FULCRUM alone will appear in the last Monday of each month. The regular features will blossom once again from September 2010 onwards.

Monday, May 24, 2010

May 2010

The mutual fund industry witnessed a 2.71 per cent growth in its assets under management in April 2010, a growth of Rs 20,836 crore to Rs 7,68,361 crore. The country's top three fund houses - Reliance Mutual Fund, HDFC Mutual Fund, and ICICI Prudential Mutual Fund - together saw their assets surge by Rs 9,376 crore, with HDFC Mutual Fund alone accounting for Rs 5,923 crore. The largest fund house, Reliance Mutual Fund, saw an addition of Rs 1,407 crore to its average assets to Rs 1.12 lakh crore. HDFC Mutual Fund’s AUM inched closer to the Rs 1 lakh crore mark to stand at Rs 94,702.79 crore. The third largest fund house, ICICI Prudential Mutual Fund, saw its assets rise by Rs 2,046.66 crore to Rs 83,036 crore. However, UTI Mutual Fund bucked the trend and saw a decline of Rs 761 crore from its assets to Rs 79,457 crore during April. In April, the average assets of Birla Sun Life Mutual Fund rose by Rs 7,165 crore to Rs 69,509 crore and L&T Mutual Fund added Rs 1,614 crore in its AUM to Rs 4,125 crore. The other fund houses which saw their average AUM rise in April include JP Morgan Mutual Fund, Edelweiss Mutual Fund, Franklin Templeton Mutual Fund, and Tata Mutual Fund. A third of the fund houses in the country saw erosion in their average AUM. They include - LIC Mutual Fund whose assets fell by Rs 1,796 crore to Rs 40,508 crore and Kotak Mahindra Mutual Fund to Rs 33,743 crore, a decline of Rs 938 crore during April. Others that saw a decline in their assets include Fortis Mutual Fund, Deutsche Mutual Fund, Mirae Asset Mutual Fund, and Shinsei Mutual Fund.

During April 2010, the BSE Sensex was marginally higher even as the overall street mood was bearish. The mutual fund industry has started the current financial year with a net outflow in the equity segment, contrary to experts’ anticipation of better inflows. In April, equity schemes witnessed net outflow of Rs 1,133 crore as against Rs 196 crore in the corresponding month last year. The equity segment has sagged since the market regulator, Securities and Exchange Board of India, banned the entry load on equity schemes from August 1, 2009. In 2009-10, the net inflow in the segment was Rs 595 crore as against Rs 1,056 crore in 2008-09. The entire distribution mechanism has regressed on the back of no commissions on the equity schemes. Thousands of distributors registered with the Association of Mutual Funds in India have not renewed their certificates for the current year. It was in July 2009, a month before SEBI’s regulation on exit load came into existence that the fund industry saw a sizeable chunk of net inflows in equity of Rs 4,432 crore, a level yet to be regained.

Although inflow was not there in equity schemes, debt funds continued to witness interest. The amount withdrawn by the corporates and banks at the end of March 2010 quarter was ploughed back into debt schemes in April 2010. After touching a record AUM of Rs 8 lakh crore in 2009, industry's average assets fell by 4.13 per cent in January while in February it rose by 3 per cent. Again it eroded by 5 per cent in March on a month-on-month basis. According to data provided by Association of Mutual Fund of India, net outflows worth Rs 1, 62,165 crore occurred in March 2010. This was the highest ever net outflow, the previous high being in December 2009. After witnessing the highest ever net outflows in March, the income category saw the highest ever net inflows to the tune of Rs 1, 77, 773 crore in April. This category witnessed net outflows of Rs 1, 64,4,87 crore in March 2010.

Leading AMCs reported strong growth numbers for FY10, despite unfavourable changes in regulations that considerably reduced inflows into their equity schemes. The rise in asset base, along with a few smart moves like relying more on debt fund management and cost control, have resulted in several fund houses turning profitable for the financial year. Top fund houses have all earned higher profits. The league table was led by HDFC Mutual Fund posting Rs 208 crore as operational profits, up 61% from 2008-09. Reliance Mutual Fund (through Reliance Capital) reported a 46% rise in net profit at Rs 184 crore and a 50% rise in net income at Rs 682 crore. ICICI Prudential Mutual Fund’s net profit has shot up from Rs 70 crore in 2008-09 to Rs 128 crore in 2009-10. The rise in profits can be attributed to a significant increase in asset base and the resulting rise in asset management charges. The assets managed by ICICI Mutual Fund have risen from Rs 59,603 crore to Rs 83,056 crore during 2009-10. Net profit of Birla Sunlife Mutual Fund has risen from Rs 30 lakh in 2008-09 to Rs 48 crore in 2009-10. Despite 2009 being a ‘no-growth’ year, fund houses have made money on procedures set in previous years. The leaner and smarter ones turned their focus completely on debt fund management. By this, they cut down on all expenses related to equity fund. This strategy did not hurt them much as fund flows into equity schemes had anyway fallen sharply. The focus on debt schemes helped them reduce costs significantly. They pushed high commission-debt products like MIPs, where asset management charges could be as high as 90-110 basis points. Apart from that, big fund houses have not witnessed redemptions, especially in equity assets, big enough to hurt them. Top funds have deep load accounts (exit load accounts) from which they meet expenses lavishly.

Piquant parade

Pramerica Asset Managers, the Indian asset management venture of US based Prudential Financial, (Pramerica Financial), has received approval of SEBI to act as the Investment Manager of Pramerica Mutual Fund. Over the next 18 months, Pramerica Mutual Fund will launch two to three equity funds and four to five debt funds, subject to SEBI approval. Pramerica joins the likes of Italian bank UniCredit's arm -- Pioneer Global, South Korea's Mirae Asset, France's Axa, and Japan's Shinsei, who have started operations in India's fiercely competitive fund industry over the last three years. IDBI Bank was the last player to receive approval from SEBI for starting its mutual funds operations. Another public sector bank, Union Bank of India has tied up with KBC Asset Management of Belgium. The joint-venture entity Union KBC AMC has also received SEBI approval and is about to start its fund business. There are 39 asset management companies now. Meanwhile, Bank of India, SREI Infrastructure Finance, Bajaj Allianz, and Indiabulls await SEBI approval to get started. Many more, including German firm Allianz and South African financial services firm Sanlam, are considering an entry into the Indian market, forecast by the Boston Consulting Group to manage $520 billion by 2015.

Fidelity Mutual Fund has announced a unique loyalty premium for investors who invested in Fidelity Equity Fund from its inception. The eligible investors will receive two free units at current NAV for every 500 units. The units will be received by eligible investor as on 18th May, 2010. The fund has delivered a CAGR of more than 25 per cent over the last five years and helped triple investor money. The fund has outperformed its category over one year as well as three year period ending May 14, 2010. While Fidelity Equity Fund’s one-year return stands at 64.08 per cent against 61.75 per cent return for its category, its three-year return is 12.02 per cent against 8.69 per cent for its category. This is a positive surprise for investors and this will be paid out to all investors who have been with Fidelity since inception and therefore have completed five years in the fund. This is a reward, but the bigger reward has actually been the performance of the fund itself.

to be continued...

Monday, May 17, 2010

May 2010
Spicy NFO treats await you this month too. From a capital protection-oriented fund to a concentrated fund and an index fund and finally some broad thematic funds…

Birla Sun Life Capital Protection Oriented Fund – Series 2

Opens: April 21, 2010
Closes: May 21, 2010

Birla Sun Life Capital Protection Oriented Fund – Series 2 is a closed end capital protection oriented scheme. The investment objective of the scheme is to seek capital protection by investing in high quality fixed income securities maturing in line with the tenure of the scheme and seeking capital appreciation by investing in equity and equity related instruments. The scheme will have duration of 36 months from the date of allotment of units. The scheme will allocate 80% - 100% of assets in debt securities and money market instruments with low to medium risk profile. It will further invest up to 20% of assets in equity and equity related instruments with high risk profile. The Benchmark Index of the scheme will be CRISIL MIP Blended Index. The scheme will be managed by Satyabrata Mohanty.

DSP Black Rock Focus 25 Fund

Opens: April 23, 2010
Closes: May 21, 2010

DSP Black Rock Focus 25 Fund is an open ended equity growth scheme investing largely in companies, which are amongst the top 200 companies by market capitalisation. The portfolio will limit exposure to companies beyond the top 200 companies by market capitalization to 20% of the net asset value. The scheme will normally hold equity and equity-related securities including equity derivatives, of up to 25 companies. The scheme will allocate 65% to 100% of assets in equity and equity related securities, which are amongst the top 200 companies by market capitalization. It will further allocate up to 35% of assets in debt securities, money market securities, and cash & cash equivalents. The scheme will have a concentrated portfolio adopting a highly flexible investment approach. A significant percentage of risk paring on account of diversification can be achieved with relatively fewer stocks, provided they are not of a similar type. While adding more stocks increases the degree of diversification, the ability of the scheme to generate relatively higher returns recedes as the number of stocks in the portfolio increases. But a focused investment strategy may mean wearing a risk profile that is perhaps a tad higher than that of diversified equity funds that have a predominant large-cap bias. In addition, having a focused portfolio would make the fund highly reliant on the fund manager's ability to consistently make the right (and well-timed) sector and stock selection. Such a high reliance on too few stocks could therefore make returns volatile, with scope for wild swings on either side. The fund may also have a higher portfolio turnover ratio given its concentrated portfolio and the need to hold outperforming stocks. DSP BR Focus 25 Fund, therefore, appears best suited only for investors with a high-risk appetite. The performance of the scheme will be benchmarked against BSE Sensex. The scheme will be managed by Apoorva Shah.

Baroda Pioneer Infrastructure Fund

Opens: May 3, 2010
Closes: May 31, 2010

Baroda Pioneer AMC has come out with Baroda Pioneer Infrastructure Fund to help you capture the investment opportunities in Indian infrastructure. The fund aims to generate long-term capital appreciation by investing in equity and equity-related securities of companies engaged in infrastructure and related areas. The fund will primarily invest in businesses such as construction, engineering, finance, energy, mining & minerals, and communications. The fund manager will invest at least 65% of the portfolio in equity and equity-related instruments of companies in above mentioned sectors. Up to 35% of the money can be invested in fixed income and money market instruments. The scheme will not have a sector or market capitalisation bias. The fund manager will invest using a combination of top down and bottom up approach to investing to ensure that a long term core infrastructure portfolio is built offering good risk adjusted returns to the investors. This fund is targeting the key catalyst which is definitely required for the growth of India, namely, building the infrastructure in order to deliver inclusive growth. There are 16 other such open-ended funds in the mutual fund industry that invest in the infrastructure theme. Baroda Pioneer Infrastructure Fund will be managed by Dipak Acharya who comes with 20 years of experience. The fund has been benchmarked against CNX 100.

IDBI Nifty Index Fund

Opens: May 3, 2010
Closes: May 31, 2010

IDBI Asset Management Company’s first fund, IDBI Nifty Index Fund, will allocate its assets in all the stocks comprising S&P CNX Nifty Index in the same weightage in which they are represented in the index. The fund will provide diversification to investors across 50 stocks in 22 sectors and will represent about 60 per cent of the National Stock Exchange’s (NSE) total market capitalisation. The scheme will allocate 95-100% of assets in Stocks in the S&P CNX Nifty Index and derivative instruments linked to the S&P CNX Nifty Index. It will invest 0 - 5% in Cash and Money Market Instruments. The fund portfolio is pre-defined and independent of human judgement. The fund intends to achieve its investment objective by minimising the tracking error between the total index returns and the fund. This is the 16th index fund to be launched in the entire mutual fund industry which tracks the S&P Nifty Index. The scheme's performance would be benchmarked against S&P CNX Nifty index. The scheme would be managed by Mr. Gautam Kaul.

Birla Sun Life India Reforms Fund

Opens: May 10, 2010
Closes: June 9, 2010

Birla Sun Life India Reforms Fund aims at generating growth and capital appreciation by building a portfolio of companies that are expected to benefit from the economic reforms, PSU divestment, and increased government spending. The scheme plans to allocate 65 per cent to 100 per cent of assets in equity and equity related instruments with medium to high risk profile. It will further allocate up to 35 per cent of assets in debt and money market instruments (including securitized debt) with low to medium risk profile. The India Reforms Fund Scheme will be invested in multiple sectors at any point in time, which may be at different stages of reform. The main aim of the BSL India Reforms Fund is to invest in such companies which would get the direct benefit and gain from various economic reforms put forth by India. Hence this is a sectoral fund with a difference since it is not entirely focused on one single sector but many which are bound to get reform benefits from Indian Government. The scheme will be managed by Mr. Ankit Sancheti and will be benchmarked against S&P CNX 500


Opens: May 17, 2010
Closes: June 14, 2010

SBI PSU Fund will mainly invest in a basket of stocks of Public Sector Undertakings (PSUs) and a small portion in debt instruments issued by PSUs. While it will invest up to 100 per cent in equities of PSU, it may also allocate up to 35 per cent in debt. Through this fund, the fund house aims at capitalising on stored value through disinvestment. Disinvestment tends to improve price discovery, valuation, and liquidity of such stocks. The fund will cherry pick PSUs that are likely to emerge as more robust and vibrant players in different industries of the economy as the disinvestment process takes place. The industries where PSUs have a strong presence are infrastructure, exploration, and exploitation of oil and natural resources, technology development, and capital goods. Currently there are two other funds falling under the equity category which follow a similar investment strategy - Sundaram BNP Paribas PSU Opportunities Fund (launched in December 2009) and Religare PSU Equity (launched in October -2009). Others are ETFs -- Kotak PSU Bank ETF and PSU Bank BeES. SBI PSU Fund will be managed by Rama Iyer Srinivasan. The fund will be benchmarked against BSE PSU Index.

Monday, May 10, 2010



May 2010

Passive investing is the average investor’s best bet. The discipline of buying during downturns lowers average cost of acquisition. Indeed, investors who continued buying systematically through the crisis are head and shoulders above the crowd. A purely passive investor will stick to systematic investments. This tried and tested approach beats over 90 per cent of active market strategies.

Only three index funds have managed to enter the elite club of GEMS in May 2010.

Benchmark Banking BeES Gem

The fund sports an AUM of Rs 70.30 crores, a dramatic slide from the Rs 7400 crore in 2007 (Rs 107.4 crores in 2009). This can primarily be attributed to the Reserve Bank of India voicing its displeasure about FIIs using it as a back door to gain entry into banking stocks and the subsequent exodus by the FIIs. But the one-year return is 65.52% as against the category average of 42.36%. The S&P CNX Nifty and the Sensex returned 36.22% and 38.39% respectively during the same period. While the expense ratio is a mere 0.5%, the portfolio turnover ratio is 218%. This is understandable, it being an ETF.

ICICI Prudential Index Fund Gem

The fund’s AUM stood at Rs 93.96 crores as on April 30, 2010. The one-year return is 35.35% as against the category average return of 42.36%. ICICI Prudential Index Fund managed a return of 21.48% over eight years with growth in the Nifty at 20.15%. This outperformance could be partially due to an element of active management. To enhance returns, ICICI Prudential Index Fund invested 15.48% of Rs 96.6 crore in the futures market on March 31 2010. The expense ratio and portfolio turnover ratio are high at 1.5% and 148% respectively. The tracking error is 2.28%.

Birla Index Fund

The total AUM of the fund is Rs 32.6 crores and its one-year return of 35.02% lags behind its category average returns of 42.36%. The fund has a high expense ratio of 1.5% and a high portfolio turnover ratio of 186%. The tracking error of the fund is 2.65%.

Can Robeco Nifty Index Fund

This Rs 9 crore fund has exhibited a lacklustre performance – a one-year return of 35.16% as against the category average of 42.36%. It has a reasonable expense ratio and portfolio turnover ratio of 1% and 10% respectively. The tracking error is 1.71%.

Franklin India Index Fund Gem

Franklin has index funds that track both the Sensex and the Nifty with AUMs of Rs 64.75 crores and Rs 131.05 crores respectively. The one-year returns have been 37.75% and 35.79% respectively with expense ratios pegged at 1% in both the funds. The portfolio turnover ratios are 15.33% and 18.29% respectively. The tracking error is 1.84%.

Principal Index Fund

Principal Index Fund has an AUM Rs 20.37 crores and a one-year return of 34.96%. The expense ratio and tracking error are reasonable at 0.82% and 0.86% respectively. The portfolio turnover ratio is 23%.

UTI Index Equity Fund

The Fund has the highest AUM of Rs 232.29 crores (low by international standards) among the index funds in India. The UTI Nifty Fund managed returns of 13.38% over 10 years with growth in the Nifty at 12.92%. UTI Nifty Fund has put some money in futures and bank deposits. This shows how index funds are trying to manage money actively to outperform the benchmark and show greater returns. They are also known to be trying to time the market, something that explains under performance leading to tracking error. The one-year returns at 34.99% lag the category average. The expense ratio is at 1.5%, the maximum limit specified for index funds by SEBI. The portfolio turnover ratio is 57.4%.

Tata Index Nifty Fund

The AUM of the fund is a dismal Rs 9.99 crores. The one year return at 35.08% lags the category average. The expense ratio at 1.5% is the maximum limit allowed. The portfolio turnover ratio is 13% and the tracking error is 0.63%.

LIC Index Fund

The LIC Index Funds replicating both the Nifty and the Sensex have AUMs of Rs 81 crores Rs 33.85 crores respectively. The one-year returns have been 32% and 35.16% respectively. The expense ratios and portfolio turnover ratios have been on the higher side at 1.37% and 1.12%, and 234% and 108% respectively. LIC Index Fund has the dubious distinction of having the highest tracking errors of 2.68% and 7.53% respectively. Overall, the performance of the funds have been dismal.

SBI Magnum Index Fund

The fund has an AUM of Rs 29.82 crores and a one-year return of 35.24%. The expense ratio, portfolio turnover ratio, and tracking error are all on the higher side at 1.5%, 184%, and 2.64% respectively. Not so encouraging performance.

Indian index funds fall prey to active investing and hold cash resulting in tracking error and expense ratio far higher than the optimum levels recommended. The funds that follow passive investing in letter and spirit are the GEMs in this category and they are the ones that should adorn your portfolio.

Monday, May 03, 2010


May 2010

Rediscovering the virtues of passivity...

For the first time, mutual funds in India are showing increased inclination towards passively managed funds after the downturn, when actively managed portfolios were hurt more than index funds. Markets are becoming more efficient, which makes it all the more difficult to beat the benchmark. With SEBI scrapping the entry load, distributor differentiation for this product has gone. Moving away from active management, a clutch of fund houses are planning to launch passively managed funds that include index funds and ETFs.

Currently, Benchmark Mutual Fund is the only fund house dedicated to ETFs. It launched a Hang Seng ETF last month and plans to launch an infrastructure ETF. IDBI Bank, while announcing its mutual fund venture recently, announced that it would launch only index funds in view of its lower expenses and simplicity. Motilal Oswal, which recently got approval to start an asset management business, has filed for a Nifty-based ETF. Reliance Mutual Fund, the largest fund house, has filed for MSCI India Growth ETF and MSCI India Value ETF. The list is growing…

This sudden clamour to launch index funds marks a drastic shift from the normal indifference to this superb investment product meant for the masses. Index funds have barely found a space inside the conscience of the average investor in India. The response to previously launched funds has been lukewarm at best. Indeed, the total assets under management in index funds are a miniscule Rs 1,204 crore, including growth and dividend schemes. In India we have two widely-tracked indices: the NSE-Nifty and the BSE-Sensex. Around 34 schemes track these two indices. Out of these schemes, six are Exchange Traded Funds (ETFs). Among the rest, 19 are Nifty-based index funds, while the remaining track the Sensex. A few of them track some sector-specific indices, such as the banking and PSE indices.

Index funds iron out incongruity

The case for indexing is gaining strength in India if one goes by the numbers. Ten years back, a majority of funds used to beat their benchmarks, but now only 50 per cent funds do that. And, the universe of actively managed funds is so large that it is difficult for investors to figure out which funds are outperforming the indices. Index funds and ETFs would become more popular once the mutual fund platform of the Bombay Stock Exchange and the National Stock Exchange became active. Currently, although these platforms exist, the number of trades is quite small. For somebody with a 10-15 year horizon, index funds made more sense as they would beat actively managed funds due to the lower fee structure. Besides, it gets increasingly difficult to beat the market on a regular basis year after year for a long period of time. Moreover, you save ample time using index funds - it operates on the principle of ‘set it and forget it’. If you buy individual stocks or actively managed funds, you will need to do a lot of research and you still are more likely to underperform an index fund! With index funds, what you see is what you get. There are few surprises, and few disappointments. These mutual funds simply track an index, and can be very inexpensive to buy and hold.

Index funds not only get the first-timer a toehold in the market. They add stability to existing fund portfolios too. At first glance, it would seem that most equity mutual funds are sitting pretty well on profits—last year, 99.03 per cent of active funds gave positive returns. Dig deeper and you find one in three active funds underperformed the bellwether Sensex. As compared to the Sensex’s returns of 76 per cent, some actively managed equity funds returned just 41 per cent. As in any bull market, the rising tide lifted most stocks and so it was not that difficult for fund managers to chalk up a positive performance. Yet, over the long run, most fund managers find it difficult to beat the averages consistently every year, year on year. The funds that are leaders of today could be the laggards of tomorrow. In the quest for market-beating performance, mutual fund investors could often chase the top performers and churn their fund portfolios. But they often find that these funds did not perform well the next year. In such a scenario, it is best to balance out their mutual fund portfolio by including index funds—funds that only track their benchmark index.

Returns without bother

The beauty of an index fund is passive management and, hence, its low cost structure. If you look at the returns, index funds have performed equally well vis-a-vis other actively-managed funds. The average return of index funds on a 5-year and 3-year basis is 18.19 per cent and 6.19 per cent respectively, whereas the average return of an actively-managed equity fund are 20.92 per cent and 8.52 respectively, for the same period, on the BSE. Among index funds, some have delivered as high as 23 per cent compared to benchmark returns of 20.79 percent. Some of the actively managed funds have given returns as low as 5 per cent on a 5-year basis, which is far lower than passively-managed index funds.

Selection of the right index fund is not rocket science. It is far easier than the selection of an actively-managed equity fund. Here, you need to look at the two main parameters: expense ratio and the tracking error. The lower the expense ratio, the better is the fund. For instance, assume you invest Rs 50,000 each in ING Nifty Plus and Franklin India Index-Nifty, for a period of 20 years. Note that while ING Nifty charges 2.5 per cent towards expenses, Franklin India Index charges 1.5 per cent. Assuming that the market grows by 15 per cent for the next 20 years on a compounded basis, Franklin India Index will yield you Rs 6,29,342, while ING Nifty will yield you Rs 5,27,254. That is a clear difference of Rs 1,02,088, or 19 per cent.

Snags that delayed its take-off...

There are various reasons why index funds have failed to take off in India so far. Fund companies were earlier reluctant to sell index funds as they considered themselves smarter than the overall market. It was probably infra dig to consider offering a product that only sought to mimic the returns given by the broader markets. The performance of most actively managed equity funds shows, however, that this feeling of superiority is a highly misplaced one. Another reason why index funds are not so popular is that not all such funds are actually purely passive in nature. Most fund managers try to beat the benchmark index by tweaking the underlying portfolio of the index. The result—a huge tracking error that puts off investors. LIC Mutual Fund has a notorious track record when it comes to tracking error. LIC MF Index Fund-Sensex Advantage Plan has an unforgivably high tracking error of 9%, followed by the LIC MF Index Fund-Nifty Plan, and LIC MF Index Fund-Sensex Plan, with tracking errors of 7% and 5% respectively. HDFC Index Fund linked to the Nifty and Sensex too run a high tracking error of 3%. In such a scenario, why would investors want to part with their money when several index funds cannot even manage to mimic the index performance? Investors in these funds only wish to participate in the stock markets without having to deal with the inherent volatility. But the way index funds are managed, most investors do not get what they have paid for.

Some of the well-managed diversified equity funds have clearly outperformed the index. The difference in outperformance is not small, but as high as 5-18 per cent in a one-year time frame, 5-9 per cent each year across a three-year time frame and 8-12 per cent every year for a five-year period. This is a huge gap and is one that typically happens in strong bull markets. One will find similar outperformance during the bullish phase of 2003-2007, where a lot of well managed diversified equity funds beat the benchmark index. However, once the equity markets entered a downtrend or even a trading range, a lot of funds were unable to beat the index and hence the entry costs mattered a lot. The consistent ones, though, have done a fine job in bearish periods, too. Besides the huge gap in returns, there is some tracking error of index funds that are visible, too. According to analysts, the ideal expense ratio for the index funds should be in the region of 0.75-1 per cent. Principle Index Fund has the lowest expense ratio of 0.75 per cent and ING Nifty Plus Fund-Growth has the highest expense ratio of 2.5 per cent. Recently, the Securities and Exchange Board of India had issued a notification to the effect that expenses charged on index funds would be capped at 1.5 per cent. For most of the funds, the tracking errors were larger than what most intelligent investors would be comfortable with.

Is it right for me?

Unlike the United States, Indian market is still to mature. There are many hidden investment gems here. These companies have the potential to generate astounding returns, despite their exclusion from the index. Index funds are unable to capitalise on these opportunities. Moreover, unlike the US, the fund management charges for Indian index funds are still high. Though they are not as high as the charges for actively managed funds, it does not make sense to pay high charges for passively managed funds. Index funds are suitable for novice investors who do not have a clue about stock market investments. Generally, one can allocate 10-15% of the equity portfolio to index funds.