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.

1 comment:

joy frankline said...

nice information shared by the author of this blog on mutual funds investment. If anybody want to secure hierfuture then invest money in mutual funds because it is the most comprehensive source of long term & beneficial investment.