Monday, May 07, 2012



The matchmaker

Investment markets are very complex. To build a portfolio of securities that consistently outperforms all other portfolios is virtually impossible. However, most portfolios do under-perform the indexes used to "measure the market." Since index funds own the stocks that make-up the index, they will perform as well as the market that the index measures. Index funds are perfect for the buy-and-hold investor - the kind of person who likes to sit back and let his investment grow, rather than moving in and out of the market in an effort to beat the market. An investor wishing his or her investment portfolio to keep pace with the market should consider index funds. Index Funds provide a perfect investment avenue for investors looking to invest into equity but not willing to take higher risks. This is because Index Funds propose to invest in companies in the same proportion as that of the underlying index. Simply put, these funds are made up of the securities that comprise major market indexes. They do not try to beat the market. Instead, they try to match it.

Footprints on the sands of time

Index funds are very, very old. Their history dates back to the 17th century. During the renaissance, world famous figures like Blaise Pascal or Edmund Halley created the basis for risk management and the theory of probability, both of which are the pillars of modern finance. The great thing about this financial instrument is the cost of index funds. Index funds require little or no active management. In most cases, computer-trading software dictates the portfolio allocation to match the chosen index. Besides the traditional index fund, there are the fundamental index funds, also known as quad funds. In this kind of funds, the index is not composed of the trends in the market, but of quantitative goals. The problem with quad funds is that, since they require active management, they have a higher fee than typical index funds (but not as high as mutual funds).

Picking the pearls…

It is fairly known that index funds are less risky compared to actively managed diversified funds. Since index funds mirror the benchmark index, they are less volatile compared to other equity-based funds. What is also known is that the risk in index funds is also lower because your investments are not at the mercy of a fund manager taking a wrong investment decision. What few investors know is how to identify the best index fund. The normal method of identifying schemes that have outperformed their benchmark indices will not work here. One should go for funds that closely map index. In other words, if a fund is giving returns higher than its index, it may not be such a great fund. The tracking error, or the difference in the returns of the index fund and its benchmark, is the most common tool for this.

But the tracking error does not capture all the deviations from the benchmark index. For example, the Nifty Junior BeES has a high tracking error (at 0.59%), but maps the index very closely and its one-year return matches that of its benchmark, the Nifty Junior. But other index funds that have a lower computed tracking error have shown more deviation from their benchmark returns.

Let us take a closer look at the factors that can influence the tracking error.

Cash component: The cash in the portfolio is a major cause of the difference in returns. The lower the cash component, the closer the fund can track the index. So it always makes sense to stick with an index fund with a lower cash component.

Fund size: If the fund size is larger, the mutual fund house will be able to manage it efficiently. Higher AUM also makes management of inflows and outflows easier as a larger corpus facilitates better cash movement. So it always makes sense to stick with an index fund of significant size.

Expense ratio: Since no active fund management is required, the expense ratios of index funds are relatively low. This should not exceed 0.5%. But in India, there are 16 index funds with expense ratios of more than 1%. And unlike the other two factors (i.e., cash component and AUM), this will remain a major drain on the scheme. In other words, investors need to avoid a scheme with a very high expense ratio even if it has a lesser "declared tracking error", because it is most likely to under perform the benchmark index in the long run.

Index composition: Liquidity of the index component and how smoothly a fund manager can get in and out of these stocks also play a crucial role in determining the tracking error. Since major indices such as Nifty and Sensex are constituted of extremely liquid stocks, the tracking error has to be relatively lower. But that will not be the case when one keeps tracking less liquid indices like Nifty Junior or CNX Bank Index. In other words, investors have to expect a higher tracking error in funds that track non-major indices.

…that suit you

While a vast majority of diversified equity mutual funds have done better than key indices in the long run, index funds are a good option for investors who are new to the market. First time investors can opt for Sensex or Nifty based funds as they have a good exposure to large cap stocks and do not bring undue volatility. Index funds are simple to understand and correlate closely with the returns offered by the market. Index funds also have lower management costs. While the charges for an actively managed fund come to around 2% of the mutual fund’s net asset value, it is between 0.5-1% for index funds. These passively managed funds provide returns that closely correspond to the gains made by their respective indices and have a tracking error (difference between index and fund returns) of about 0.5%. These funds also have a lower risk return ratio compared to actively managed equity funds. Index funds typically bring lower returns in a rising market but fall less sharply during a downturn.

Not the best option in India…

Index funds are a relatively small part of the overall mutual fund industry in India, and this is markedly different from the west, where index funds do quite well, and in fact the biggest fund in the US is an index fund (SPY) that tracks the popular S&P 500 index. Indian indices like the Sensex (30) and the Nifty (50) cover a relatively small number of stocks and ignore many opportunities in the mid-cap sector. An index fund that invests in just 30 or 50 stocks clearly does not offer a great deal of diversification. Contrast this with Vanguard 500 in the US, which tracks the changes in 500 stocks of the S&P 500 index. The basic principle here is: the more the number of stocks comprising an index the better is the diversification and price discovery. Unlike the capital markets in developed countries, Indian markets have not been thoroughly researched which means that there may be more opportunities to beat the market by sound research. Finally, one of the biggest advantages of index funds: their very low expense ratios are less relevant to India where expenses are quite high. Any mutual fund, be it an index fund or a gold exchange traded fund or an equity mutual fund, needs to spend money on marketing the project, pay the fund manager and other such expenses. These expenses as a percentage of total money collected to run the scheme is the expense ratio. US index funds like the Fidelity Spartan 500 have expense ratios as low as 0.1 per cent, while Indian index funds have expense ratios as high as 1-1.5 per cent. This is not that much lower than active funds like the HDFC equity fund with expense ratios of around 2 per cent.

… but potentially rewarding

This does not mean that Indian investors should permanently ignore index funds. In a few years, many of their shortcomings in the Indian context may be resolved. As capital markets mature and the quality of research increases, it will be harder to generate high returns through stock-picking and active strategies. With increased competition, expense ratios in Indian index funds may fall making them more attractive relative to active funds. While the markets may be overvalued today that will not be the case indefinitely. While index funds may not be the best investment vehicle today, they are a potentially rewarding investment that all savvy investors should understand.

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