Monday, May 02, 2011

May 2011

Index Funds - one up on Active Funds!

Index mutual funds are about investing in securities of a particular (targeted) index in an equal proportion. These investments tend to be passive by nature and so it would mean that the manager of the portfolio would distribute the assets of the fund across several stocks that are part of the index. This distribution is done in equal proportion as the weights in a particular index. The idea behind these investments is to reflect the movement of the index. There are several good reasons to invest in index mutual funds. For one, the expenses involved are much lower. In addition, these investments have very low recurring expenses. Secondly, these investments are made up of stocks of a very high quality, which include liquid, much traded, large cap and blue chip stocks. In addition, with these investment vehicles, you can also diversify your portfolio and this means that you also stand to enjoy all the benefits that are normally associated with diversification. Finally, when dealing with index mutual funds, you also stand to exercise maximum control over your portfolio’s risk. This is because you are shielded from fads as well as trends, which are normally associated with active investing.

Statistics Support

Indexing has legions of diehard believers. A parade of studies has shown why: Index funds, which try to simply match the performance of a broad market sector, have consistently beaten "actively managed" funds, where professional money managers attempt to outperform the market by picking the hottest stocks and bonds. Over the 23 years ending in 2009, 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%, while an index fund would have returned 9.8% to 9.9%, giving up only a small amount for fees.

Alpha on Active Funds

But if this is so, why do a majority of investors still choose active management? Indexing, or "passive management," accounts for only about 13% of assets in mutual funds holding stocks. It does not seem to make sense. Experts have offered a variety of explanations all of which point the index finger to the gullible investor. Investor preferences between passively managed and active funds appear to be dictated less by their intrinsic appeal than by the marketing tactics of banks and fund managers. Banks are aggressive in marketing their active funds, and they compare their funds to the historical returns of 40% or more with the 8% on their fixed deposits. Banks have 56% of public savings with them. If banks themselves market the funds, there could be a decent shift [away from bank deposits to mutual funds] in the next few years. But new research shows that investors who embrace active management may, in fact, be behaving perfectly rationally. Investors are in a kind of eternal struggle each hoping the others will withdraw to make it more likely that the remaining managers will find the nuggets. For active managers, the Holy Grail is "alpha," the industry's term for a return that exceeds the market average when the investment's risk is taken into account.

Fighting for shelf space

Unfortunately, Index Funds have not really taken off in India so far. According to the Association of Mutual Funds of India (AMFI) data, index funds comprise of only 0.3% of the total industry assets. In comparison, index funds comprise about 9% of the mutual fund industry in the US. Why have index funds not taken off then? Agents have traditionally sold products that fetched higher commission. Index funds are low-cost products and hence do not pay much commission. Hence the market did not take off as much as we had anticipated. Index funds are not a paying proposition. But that is not the only reason why index funds did not pick up. Contrary to developed markets such as the US where fund managers have repeatedly found it tough to beat indices, in India actively managed funds have outperformed passive funds, consistently. There is immense talent in the Indian mutual fund industry. We have more than 6,000 listed companies on our stock markets; it is not very tough for a capable fund manager to pick about 100-150 stocks of these that can outshine the market.

Raring to go…

Benchmark’s acquisition by Goldman Sachs has not deterred others from launching ETFs and index funds in India. India Infoline Asset Management Co. Ltd, that got its mutual fund licence recently, aims to launch passive funds initially and manage them for about a year. Motilal Oswal Asset Management Co. Ltd that started its operations in 2010 also aims to stick to ETFs, as will IDBI Asset Management Co. Ltd that will mainly focus on index funds. ICICI Prudential AMC may get aggressive and apart from educating stock brokers to recommend ETFs to investors who need them, will also look at launching specialized ETFs such as country-specific ETFs.

…aiding the much-needed transition

Active funds are set to dominate the Indian market for a few more years until investors get better educated about passive funds. Many investors invest in mutual funds assuming that they provide higher returns. But the concept of mutual funds is to diversify risk, and that is not widely understood in India. The lack of an independent rating agency in India like Morningstar in the U.S is another dampener. There is respite coming on that front with the Indian markets regulator, the Securities and Exchange Board of India, setting up the National Institute for Securities Markets, which is working to set up something like Morningstar to [form] a central database, to independently assess mutual funds or stocks and disseminate information about them. In the Indian context, participation of retail savers is low in the stock market. So index fund is the simplest of product to understand as it has minimum post purchase dissonance.

No comments: