FUND FLAVOUR

May 2013

Index Funds – a bird’s eyeview

An index fund is a passive investment with investment done in the stocks of a benchmark index. Index funds are mutual funds with an objective to generate returns that commensurate with the performance of a benchmark index.  As such, the fund manager selects a combination of assets for a portfolio that is intended to mimic an index, such as the Sensex or the Nifty. Because the fund's underlying assets are held and not actively traded, operating expenses are usually lower as there is no research or high management overhead.

Both sides of the scale

Index funds are advantageous for risk-averse investors. The various advantages of Index Funds are they are easily understandable with returns always in line with the benchmark index, automatic clean-up of portfolio, absence of security specific risk, easier management of portfolio, suitability for efficient markets, low transaction costs, low expense ratio, less risk, and low dependence on performance of fund manager. Absence of outperformance and lack of options are the two major disadvantages of index funds.

A closer look

To some investors, it is reasonable to assume that all index funds perform the same. However, a deeper look will uncover all sorts of discrepancies between funds.

Expense ratio: Since there is no research or higher management costs, the costs of index fund should be relatively low. E.g. for IDFC Index Nifty fund, the expense ratio is 0.25% and followed by Reliance Index Nifty fund at 0.40%.

Tracking error: If all the Index funds track the same index, then every index fund should offer the same return. Then our choice is to pick-up a low expense ratio. However you need to check the tracking error. The returns generated by an index fund may vary due to returns generated by underlying index. This deviation from index fund returns is called tracking error. Generally low tracking error funds are good.

Index funds in India

Today, there are not enough passive funds for executing all types of investment strategies. For instance, there is only one mid-cap ETF (from Motilal Oswal AMC). On the debt side, there is a severe lack of options (only 10-year G-sec funds are available). The overwhelming majority of funds are based on the Nifty and the Sensex. The universe of passive funds available to Indian investors needs to grow. The category has 45 active funds (only primary funds included) and 30 passive ones. Their cumulative asset under management (AUM) is small: Rs 1,758 crore vis-a-vis Rs 24,663 crore for active funds. However, their proliferation indicates that fund houses are preparing for the day when investor preference might shift to passive funds in this segment.

Why Index funds in India have not become popular?

There are two aspects to this – the first is that actively managed funds have performed better than index funds in the past and people expect that to continue in the future as well. There are several types of mutual funds, which are offering 10 to 15% (annualized returns in the last three years of large cap and diversified mutual funds are 13% and 17% respectively) annualized returns in the last few years. However, returns of index funds range from 4% to 8%. Mutual fund schemes invest in best performing stocks, growing companies, for long term hence the returns are higher compared to index funds. Secondly, index funds are not really low cost in India.

Then, when are Index funds good to invest?

·      Investors who want to take advantage of stock market crashes and want to invest directly in SENSEX or NIFTY.     

           Investors who want to invest in all stocks across index instead of investing in a few stocks or a mutual fund, which picks up only based on its investment objective. 

            Investors who are willing to take risk as investment in index would reflect the stock market volatility

The Bottom Line

If you are an investor who would like to invest in an index fund, be sure to look beyond just the cover. Not all index funds perform the same. Expense ratios, fees and tracking errors can drastically affect an index fund's performance. Investors should carefully investigate an index fund before buying in to make sure that its fees are low and that they have a firm understanding of what the fund invests in, as well as the strategies and goals that management uses to meet its objectives. Index funds can be very dependable investments, but investors are more likely to find one they can count on if they weed out any element of surprise.