FUND FULCRUM

May 2014

The average assets under management of mutual funds witnessed a 14.6% rise to touch a record Rs 9.45 lakh crore in April 2014 on the back of a spurt in inflows into liquid funds, according to rating agency CRISIL. Assets under equity funds gained for the third consecutive month, tracking the uptick in the equity indices. According to the agency, liquid funds attracted inflows of Rs 1.24 lakh crore, which is the biggest in three years, as corporates and banks ploughed the surplus money back into the funds that were withdrawn in March 2014 due to advance tax payout and requirement during the end of the fiscal period. The liquid funds' assets rose 94.6% to touch Rs 2.59 lakh crore by April 2014. However, income funds registered outflows, with assets under this category touching Rs 4.58 lakh crore, mainly due to outflows from close-ended and interval funds. Gilt funds saw outflow for the fifth consecutive month with AUM falling to Rs 5,895 crore in April 2014. However, equity fund AUM gained for the third month in a row with April 2014 witnessing a gain of 0.6% or Rs 1,139 crore to Rs 1.92 lakh crore. The gains were led primarily by mark to market gains in the broad market. Meanwhile, investors continued to exit gold exchange traded funds (ETFs) for the eleventh straight month with consolidated outflows amounting to Rs 2,400 crore till April 2014. Other ETFs saw record outflows of Rs 1,213 crore and assets declined 18.20% to Rs 3,700 crore in April 2014. Fund of funds investing overseas too saw outflows with the category's AUM falling by 0.2% to stand at Rs 3,186 crore as of April 2014.

 

During the entire financial year 2013-14, mutual funds had garnered nearly Rs 54,000 crore from investors as against over Rs 76,539 crore in the preceding fiscal. ICICI Prudential, IDFC, and Birla Sun Life emerged as the highest gainers in equity assets. ICICI Prudential recorded the highest growth (absolute terms) in equity assets. Its equity AUM increased by Rs. 3,675 crore or 22%. Eighth largest fund house by assets IDFC saw its equity AUM jump by 27% or Rs. 1619 crore while Birla Sun Life and Kotak saw their equity assets increase by Rs. 619 crore and Rs. 232 crore respectively. India's largest fund houses, HDFC and Reliance saw their equity assets dip by Rs. 2,741 crore and Rs. 426 crore respectively. SBI and UTI too recorded a decline in their equity assets by 9% and 7% respectively. Among the top ten fund houses, DSP BlackRock too witnessed a decline of 22% in its equity AUM. Its equity assets fell from Rs. 10,796 crore to Rs. 8,437 crore in FY 2013-14. Though the equity AUM of industry has grown, no new investments have come in equity funds. Thanks to mark-to-market gains and closed-end equity funds launches, equity AUM of the industry grew by 11% from Rs. 1.72 lakh crore to Rs. 1.91 lakh crore in FY 2013-14. However, total equity AUM of the top ten fund houses saw a marginal decline of 2% from Rs. 1.55 lakh crore to Rs. 1.53 lakh crore. This decline can be attributed to redemptions as many investors exited equity mutual funds after booking profits. The S&P BSE Sensex rose by 19% while CNX Nifty grew 18%. Equity funds saw net outflows of Rs. 9,268 crore.

Mutual funds lost about 33 lakh investors, measured in terms of individual accounts or folios, in the financial year 2013-14, primarily on account of volatility in the equity market. It was the fifth consecutive year of loss of folios by mutual funds. According to market regulator SEBI’s data, on total investor accounts with 44 fund houses, the number of folios fell to around 3.95 crore at the end of 2013-14, from 4.28 crore in the financial year 2012-13. In the past five financial years till 2013-14, the mutual fund industry had lost more than 88 lakh investor accounts. Mutual fund sector, which held 4.75 crore folios at the end of financial year 2008-09, saw an increase of 3.66 lakh new investors account to 4.8 crore in 2009-10. However, later the number of folios continued to witness a southward trend and tumbled to 3.95 crore during 2013-14. The number of investor folios for equity schemes fell by 40 lakh during 2013-14. The total number of folios in equity funds were 2.92 crore by the end of 2013-14, as against 3.31 crore by the end of the preceding fiscal. According to SEBI data, the total number of folios in debt funds rose by about 7.28 lakh to 68.67 lakh at the end of March 2013. Balanced schemes, which invest in equity and debt category, gained 10,824 folios to end at 26.13 lakh during the last financial year. However, exchange traded funds saw a drop of 34,773 folios to 7.04 lakh investor accounts at the end of March 2014.

Piquant Parade

The mutual fund industry has been going through a consolidation phase. Birla Sun Life Asset Management Company, part of the Aditya Birla Financial Services Group, has acquired the mutual fund schemes and portfolio management services of ING Investment Management (India), part of the Dutch financial services company ING. With this acquisition, Birla Sun Life Mutual Fund has added Rs 1,100 crore to its assets under management (AUM). This is yet another exit of a foreign mutual fund from its Indian operations. The Dutch financial services company has been looking to exit its AMC and insurance business in Asia for long. In December 2013, HDFC Mutual Fund had bought schemes of Morgan Stanley. Earlier, Japan based AMC, Daiwa Mutual Fund sold its schemes to SBI Mutual Fund and Fidelity sold its AMC businesses to L&T MF.

Sundaram BNP Paribas Fund Services has bagged the International Standards for Assurance Engagements (ISAE) Type II certification for high quality operating models and effective controls. Sundaram BNP Paribas Fund Services has the unique distinction of being the only RTA (registrar and transfer agent) in the country to have been awarded the ISAE Type II certification for high quality operating models and effective controls. The certification is a reflection of better quality data, richer experience and basically, a reassurance on the effectiveness of the design and controls of the operating model. Sundaram BNP Paribas Fund Services had already completed its assessment for ISAE Type I certification in the year 2013.

Mutual fund industry’s much-awaited platform MF Utility is closer to reality. The platform will be unveiled in two phases. Channel partners will be appointed in the second phase. The platform will be owned by all AMCs. The platform will help advisors cut down their operational costs. A common account number will be allotted to an investor which can be used to log in and invest across all mutual funds. An investor can invest in multiple schemes with a single cheque. Distributors can get industry wide consolidated MIS. Distributors can make data entry in the portal. The portal will have five bank mandates for individual investors and seven for corporates. Distributors will have access to account statement based on their ARN. The portal will generate different types of alerts. Distributors have to scan and upload the forms on the portal which they can submit to the R&T later. Time stamping will be done immediately after forms are uploaded.

Regulatory Rigmarole

AMFI has come out with fresh set of guidelines for product labelling to standardize the methodology for colour coding schemes. SEBI had introduced product labelling so that investors can make an informed choice regarding the suitability of products based on their risk appetite. As per earlier SEBI guidelines, schemes with low risk were denoted with blue colour, those with medium risk were assigned yellow and schemes with high risk brown colour mark. However, there was confusion regarding its implementation among AMCs. AMCs were following different methods to classify their schemes. To end this confusion, SEBI had asked AMFI to standardize the methodology for uniform application of product labelling across industry. All debt-oriented schemes, comparatively lower in risk, will be denoted with ‘Blue’ colour. All diversified/blended schemes, with a mix of debt and equity into the portfolio construct, will be assigned ‘yellow’ colour to indicate moderate risk. All equity-oriented schemes will have ‘brown’ colour to show higher risk. All static allocations domestic feeder funds which have a predominant equity allocation will be colour-coded as ‘brown’ and which have a predominant debt allocation should be colour coded as ‘yellow’. All active allocations domestic feeder funds (i.e., where the allocation is based on a model or parameter etc.) will be colour-coded as ‘brown’. All foreign feeder funds will be colour-coded as ‘brown’. The revised guidelines will be effective from July 01.

AMFI, in its best practice circular, has clarified that in-person verification of investors can be done through web camera. SEBI’s new KYC rule which came into effect from January 2012, required distributors to personally verify their clients, a process known as in-person verification (IPV). Individual investors are required to undergo In-Person Verification (IPV) as a part of updation of additional/ missing information with KRA. In-person verification through web camera can be performed by any intermediary and records of the same shall be maintained, according to the AMFI circular. IPV can be done by any SEBI registered entity like an AMC or NISM/AMFI certified distributors who are KYD compliant. Banks are also allowed to do IPV.

While AMCs are preparing to raise their net worth, they are unhappy with SEBI’s decision to raise net worth to Rs. 50 crore instead of Rs. 25 crore recommended by SEBI Mutual Fund Advisory Committee. SEBI has raised the net worth of AMCs to Rs. 50 crore in its gazette notification published on May 06, 2014. AMCs which do not have Rs. 50 crore net worth get three years to comply with this regulation. In the meanwhile, they cannot launch any new schemes. SEBI has kept closed-end schemes exempt from this rule. Further, the net worth capital rule of SEBI is far higher than what is required in countries like US, Japan, and UK.

Stringent compliance requirements under Foreign Account Tax Compliance Act (FATCA) have led several fund houses to stop taking fresh investments from US investors. The FATCA regulations (an anti-tax evasion law) will come into effect from July 1, 2014. Once implemented, fund houses will be required to report information on US investors to US IRS (Internal Revenue Service) through CBDT. India has agreed ‘in substance’ to FATCA by signing an Intergovernmental Agreement (IGA) with US. There are hardly any US investors who are investing in Indian funds. US citizens can anyway invest in funds which are domiciled locally which have exposure to India. Fund houses are not accepting investments from investors residing in Canada either because the Canadian Securities Administrator (CSA) requires AMCs to register with it before selling any schemes to its residents. If existing investors subsequently become U.S. or Canada residents, they too will not be able to make any additional investments. Fund houses have allowed existing US citizens to redeem their investments from their schemes.

In order to boost investor participation into mutual funds from smaller cities, SEBI has allowed asset management companies to accept cash investments of up to Rs 50,000. Earlier, the cash transaction limit was set at Rs 20,000. This would help mobilise funds from beyond 15 cities. Although SEBI has allowed cash transaction up to Rs 50,000, it has said the repayments, dividends for all investments will continue to be paid only through the banking channels. Currently, only a few fund houses like UTI MF and SBI MF offer the facility of cash transactions to investors.  A lot of fund houses had taken a conscious decision of not accepting cash. Cash investments are aimed at those investors who want to invest in the so-called micro systematic investment plans (Micro SIPs). Micro SIP is a facility that allows investors to invest in very small tranches at periodic intervals. The KYC norms too are relaxed for Micro SIPs investments.

Indian mutual fund houses seem to have finally cracked the code for attracting investors from outside the big cities. More than half the folios, or accounts, opened in 2013-14 under a Systematic Investment Plan have come from tier-II or smaller cities — known in sector parlance as B-15, meaning, beyond the top 15 cities. From data provided by registrar Computer Age Management Services, 53% of the nearly 700,000 SIP folios opened in FY14 came from B-15. This data covers about 60% of the sector size. The concerted efforts to ensure the reach extended beyond the top cities could have finally begun to yield results. However, given the low investment size in smaller centres, the assets under management from B-15 was only a third of the total from SIPs. According to sector estimates, the average equity size in a B-15 centre was Rs 1,000-2,000, compared to Rs 5,000-10,000 in the top 15 cities. The total AUM under SIPs was Rs 39,449 crore as at end-March 2014. While the number of SIP folios coming in from the smaller centres has increased, the corpus remains low, as the average ticket size there is much smaller. Growing investment from smaller cities is an encouraging sign for the Rs 8 lakh crore MF sector.

NFO NEST

May 2014

NFO mania closing in on close ended equity funds

It is a season of new equity fund offers. The category, which had gone into a long slumber after the Lehman crisis, has suddenly started showing a gust of launches. As many as 24 NFOs in the equity segment have hit the market over the past six months, garnering nearly Rs 3,000 crore. An earlier trend of close-ended equity schemes has also resurfaced. Rather, a majority of equity NFOs were close-ended products, with a lock-in period of two to five years. ICICI Prudential, Reliance, and IDFC were among the prime fund houses which launched such schemes.

The euphoria surrounding close end funds does not seem to have subsided yet. Three more fund houses – Birla Sun Life, Reliance, and Sundaram have come out with their NFOs to launch close-end equity funds. Thus, three out of the five NFOs in the April 2014 NFONEST fall in the close-end equity fund category.

Sundaram Top 100 - Series II

Opens: May 5, 2014

Closes: May 23, 2014

Sundaram Mutual Fund has unveiled a new fund named as Sundaram Top 100 - Series II, a close ended equity fund with a tenure of three years from the date of allotment. Sundaram TOP 100, intended as a wealth building tool for investors, endeavours to unearth the deep value hidden in several Indian companies. The investment objective of the fund is to generate capital appreciation from a portfolio that is substantially constituted of equity securities specified as eligible securities for Rajiv Gandhi Equity Savings Scheme, 2012. The fund will invest 95%-100% of assets in equity securities specified as eligible securities for RGESS with medium to high risk profile and invest up to 5% of assets in cash and cash equivalents and money market securities with low to medium risk profile. Investments made in money market instruments shall have residual maturity of up to 91 days. Benchmark Index for the fund is CNX 100. The fund will be managed by J. Venkatesan.

Reliance Close Ended Equity Fund II - Series A (G)

Opens: May 9, 2014

Closes: May 23, 2014

Reliance Mutual Fund has launched a new fund named as Reliance Close Ended Equity Fund II - Series A, a close ended equity oriented fund. The tenure of the fund shall be five years from the date of allotment. The investment objective of the fund is to provide capital appreciation to the investors, which will be in line with their long term savings goal, by investing in a diversified portfolio of equity and equity related instruments with small exposure to fixed income securities. The fund will allocate 80% to 100% of assets in equity and equity related instruments with high to medium risk profile and it would allocate up to 20% of assets in debt and money market instruments with medium to low risk profile. Benchmark Index for the fund is S&P BSE 200 Index. The fund managers are Shailesh Raj Bhan and Jahnvee Shah.

Birla Sun Life Emerging Leaders Fund - Series 2

Opens: May 16, 2014

Closes: May 26, 2014

Birla Sun Life Mutual Fund has launched a new fund named as Birla Sun Life Emerging Leaders Fund - Series 2, a close ended equity fund. The fund will have a duration of three years from the date of allotment. The primary objective of the fund is to generate long-term capital appreciation by investing predominantly in equity and equity related securities of small and mid cap companies. The fund would invest 80% to 100% of assets in equity and equity related securities out of which 70%-100% will be in small and midcaps and up to 30% in securities other than small and midcaps.  Up to 30% will be invested in securities with high risk profile and 20% of assets will be in cash, money market, and debt instruments with low risk profile. Benchmark Index for the fund is S&P BSE Midcap Index. The fund manager will be Hitesh Zaveri.

ICICI Prudential Multiple Yield Fund - Series 6 – Plan F

Opens: May 15, 2014

Closes: May 28, 2014

ICICI Prudential Mutual Fund has launched a new fund as ICICI Prudential Multiple Yield Fund - Series 6 - Plan F, a close ended income fund. The tenure of the plan is 1100 days. The primary objective of the fund is to seek to generate returns by investing in a portfolio of fixed income securities/ debt instruments. The secondary objective of the fund is to generate long term capital appreciation by investing a portion of the fund's assets in equity and equity related instruments. The fund will allocate 70% to 95% of assets in debt securities (including government securities) with low to medium risk profile. It would allocate up to 20% of assets in money market instruments, cash and cash equivalents with low to medium risk profile and it would allocate 5% to 30% of the assets in equity or equity related securities with medium to high risk profile. Out of the investments in debt instruments, 82%-87% would be invested in AA rated non convertible debentures. The benchmark index for the fund will be Crisil MIP Blended Index. Rahul Goswami and Aditya Pagaria will jointly manage the debt portion and equity portion will be managed by Rajat Chandak. The investments under the ADRs/GDRs and other foreign securities will be managed by Abhishek Pathak.

HDFC Capital Protection Oriented Fund - Series II (36M) May 14 – Regular (G)

Opens: May 16, 2014

Closes: May 30, 2014

HDFC Mutual Fund has launched a new plan named as HDFC Capital Protection Oriented Fund- Series II - 36M May 2014, a close ended capital protection oriented fund with the duration of 36 months from the date of allotment. The investment objective of the plan is to generate returns by investing in a portfolio of debt and money market securities which mature on or before the date of maturity of the fund. The fund also seeks to invest a portion of the portfolio in equity and equity related securities to achieve capital appreciation. The plan would invest 75% to 100% of assets in debt and money market instruments with low to medium risk profile and invest up to 25% in equity and equity related instruments (including equity derivatives) with high risk profile. Benchmark Index for the plan is CRISIL MIP Blended Index. The fund managers are Anil Bamboli (Debt Portfolio) and Vinay R Kulkarni (Equity Portfolio). Rakesh Vyas will be dedicated fund manger for Overseas Investments.

ICICI Prudential Value Fund Series – 5 to 8, ICICI Prudential Small Cap Fund, UTI Capital Protection Oriented Fund – Series IV, Sundaram Select Small cap Series II-IV, Reliance Debt Opportunities Fund (Plan A to E), DWS Global Top Dividend Fund, Kotak Equity Monthly Income Plan, Axis Ultra Short Term Fund, Axis Medium Term Fund, DSP Blackrock Japan Nikkei 225 Fund, DSP BlackRock European Fund, DSP BlackRock World Healthscience Fund, DWS German Equities Fund, DWS Corporate Debt Opportunities Fund, SBI Dual Advantage Fund – series IV – VI, Birla Sunlife Emerging Leaders Fund – Series 3 & 4, LIC Nomura Diversified Equity Fund – Series 1 & 2 are expected to be launched in the coming months.

GEMGAZE

May 2014

 

If you want to invest in equity mutual funds but are not confident about the abilities of the fund managers, index funds are a good option for you. Index funds are equity funds that replicate a particular equity index by investing in the stocks that the index tracks. As each stock has different weightage in an index, the portfolio of an index fund is also allocated in a way to mirror that of the index. 

Four of the five sparkling GEMs among the index funds in India in 2013 have retained their preeminent status in 2014 also. Can Robeco Nifty Index Fund is out of the race by virtue of it having been merged with Can Robeco Largecap Fund. UTI Nifty Index Fund and Tata Index Nifty Fund have joined the elite group after a brief wait.

Goldman Sachs Nifty BeES Gem

 

Launched in December 2001, Goldman Sachs Nifty BeES, the first ETF in India, has an AUM of Rs 369 crore. Large caps rule the roost with 98% of the portfolio in large cap stocks. 99.8% of the assets are in equities. 58.77% of the assets are in the top three sectors, finance, technology, and energy. The one-year return of the fund is 13.48%, slightly trailing the category average of 14.68%. The returns of the fund are benchmarked against the CNX Nifty Index. The expense ratio of the fund is 0.54% and the portfolio turnover ratio is 64%.

 

ICICI Prudential Index Fund Gem 

 

The AUM of ICICI Prudential Index Fund, launched in February 2002, which has been hovering around Rs 96.5 crore during the past couple of years, has reached Rs 73 crore at present. Large caps constitute 98% of the portfolio, with 98% of the assets in equity. The top three sectors, finance, technology, and energy, account for 53.05% of the portfolio. The one-year return of the fund is 14.87%, slightly above the category average of 14.68%. The returns of the fund are benchmarked against the CNX Nifty. The expense ratio of the fund is 0.77% and the portfolio turnover ratio is 69%.

 

Franklin India Index Fund Gem

 

The AUM of Franklin India Index Fund, launched in July 2000, is Rs 132 crores. Large caps constitute 98% of the portfolio, with 99% of the assets in equity. The top three sectors, finance, technology, and energy account for 58.39% of the portfolio. The one-year return of the fund is 13.54%, as against the category average of 14.68%. The returns of the fund are benchmarked against the CNX Nifty. The expense ratio of the fund is 1.06% and the portfolio turnover ratio is 15%.

 

Principal Index Fund Gem

 

Launched in June 1999, the AUM of Franklin India Index Fund is Rs. 8 crores. Large caps constitute 98% of the portfolio, with 99% of the assets in equity. The top three sectors, finance, technology, and energy account for 58.87% of the portfolio. The one-year return of the fund is 13.82%, as against the category average of 14.68%. The returns of the fund are benchmarked against the CNX Nifty. The expense ratio of the fund is 1% and the portfolio turnover ratio is 94%.

 

HDFC Index Sensex Plus Fund Gem

 

Launched in July 2002, HDFC Index Sensex Plus Fund sports an AUM of Rs 79 crore. This fund has always had a large-cap tilt with 92% in large caps and 99% in equity. The one-year return of the fund is 14.22% as against the category average of 14.68%. The top three sectors of the fund are finance, energy, and technology. 55.33% of the assets are in the top three sectors. The fund is benchmarked against the S & P BSE Sensex. The expense ratio of the fund is 1.06% and the portfolio turnover ratio is 43%.

 

UTI Nifty Index Fund Gem

 

The AUM of UTI Nifty Index Fund is Rs 140 crores. This open-ended passive fund was created by merging UTI Sunder and UTI Master Index fund on March 14, 2012. Large caps constitute 98% of the portfolio, with 99% of the assets in equity. The top three sectors, finance, technology, and energy account for 58.49% of the portfolio. The one-year return of the fund is 13.52%, as against the category average of 14.68%. The returns of the fund are benchmarked against CNX Nifty. The expense ratio of the fund is 1.83% and the portfolio turnover ratio is 68%.

 

Tata Index Nifty Fund Gem

 

Launched in February 2003, the AUM of Tata Index Nifty Fund is Rs 5 crores. Large caps constitute 99% of the portfolio, with 100% of the assets in equity. The top three sectors, finance, technology, and energy, account for 59.04% of the portfolio. The one-year return of the fund is 12.82% as against the category average of 14.68%. The returns of the fund are benchmarked against CNX Nifty. The expense ratio of the fund is 1.77% and the portfolio turnover ratio is 11%.

FUND FLAVOUR

May 2014

 

Active vs. Passive Approaches
 

One of the greatest debates in the investment world centers on whether mutual fund managers, in the aggregate, add any value for investors. Since Vanguard introduced the first index fund in the 1970s, skeptics and critics of the financial services industry have argued that professional money managers have failed to live up to our expectations. Taking all of them together, they simply do not do any better than a random selection of securities in any given market or investment style. On the other hand, there are many managers who have demonstrated that they can outperform a random selection of securities, even after subtracting their fees – you just need to know how to identify them. Furthermore, an active manager can provide benefits that a random basket of securities cannot. An active manager can hold more cash when things look ugly, or sidestep some bad news at a company by selling before the whole thing collapses. In contrast, indexers have to ride the bus off the cliff.

Who is right? Well, if you have to ask, then it is time to go back to the basics and look at how mutual funds – including index funds – are designed and built. You must also examine some of the key metrics. As with so many aspects of investing, context counts, and there is frequently a time and a place for both approaches. When you have a manager – or team of managers – that actively buys and sells selected securities in order to maximize return, minimize risk, or both, that approach is called active management. But what if you did not need to pay a team of analysts to sit around all day and analyze securities? It turns out you can, by means of a special kind of mutual fund called an index fund. Index funds are still mutual funds, arrangements in which you pool your money with other investors. And you still have an investment company that handles your transactions. The difference is that the investment company is not paying a fund manager and a team of analysts to try to cherry-pick stocks and bonds. Instead, the fund cuts out the middlemen, saves the investors their salaries, and just buys everything in the particular index it aims to replicate. This index could track stocks, bonds, or REITs, for example.   

Index funds – one up on active funds

Index funds offer built-in benefits. For the most part, index funds do not attempt to outperform their benchmark, but rather match the benchmark's performance. Index funds invest passively in a portfolio constructed to match or track the components of a broader market index, such as the Nifty. Index funds do not keep your money idle in cash. It is not uncommon for actively managed funds to keep 2% to 10% of their portfolios in cash. That cash can cost shareholders 0.5% a year in return, with no corresponding benefit. You get wide diversification in a single package. Index funds give you control of your exposure to the specific asset classes you want. In an actively managed fund, there is always the risk that a manager will acquire stocks that may seem attractive even though they do not fit the fund’s intentions. Index funds also eliminate the risk of duplication, which can leave you owning several funds that all own the same stocks. These funds have a much lower expense ratio. The absence of active management takes away a lot of risk involved in stock picking and market timing and reduces portfolio turnover ratio. Hence, index funds are potentially more tax efficient. You will most likely get above-average returns. Of course there is no guarantee, but if you buy an index fund and hold it for the long term, your return is likely to be among the top 10% of all returns for funds in that asset class. You will not have to worry about monitoring the performance of an index fund manager. The manager’s only stock-picking role is strictly mechanical - to mirror what is in the index. This is simple and inexpensive. And it is very easy to compare your performance with that of its index. They should be extremely close. Once you have found index funds in the asset classes you want, you do not have to do anything. The only exceptions are adding new money, withdrawing money, periodic rebalancing and occasionally changing the mix of your equity and bond exposure.

On the flip side

The biggest disadvantage is that there is no chance of outperforming the index or beating the market, which is possible with an actively managed equity fund. An index fund does not carry the potential to outpace the market the way that managed funds can. This means that if you invest in an index fund you are surrendering the possibility of a massive gain. The top-performing non-index funds in a given year perform better than the top-performing index funds, and the very best non-index funds can perform far better than an index fund in a year. However, the top-performing non-index funds may vary from year to year, so that under-performing years can cancel out the over-performing ones, while index funds' performance remains steady. Index funds are suitable for those who want to invest in equity but do not want to take the higher risk inherent in traditional equity funds. Because index fund managers must follow policies and strategies that require them to attempt to perform in lockstep with an index, they enjoy less flexibility than managed funds. Investment decisions on index funds must be made within the constraints of matching index returns. For instance, if the returns in an index are declining strongly, index fund managers have few options in an attempt to limit those losses. In contrast, managers of an actively managed fund have more flexibility to act to find better-performing options in good times or in bad.

Because of these built-in structural advantages which far outweigh the disadvantages, one would expect index funds to routinely outperform the median performance of actively managed funds that invest in the same category. Index funds cannot beat the index, but because they approximate the returns of the index while minimizing expenses, the lower expenses should give index funds a noticeable advantage. We would not expect to find a low-cost index fund in the bottom half of the universe of mutual funds with a similar investment style for a long time.

Why is investing in index funds not popular 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. 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, and secondly, index funds are not really low cost in India. The question then is why do active funds do better than index funds in India? The markets in the west are so deep and developed that they are efficient to a large extent and it is difficult for stock pickers to find mis-pricings and benefit from them. Indian markets are not so efficient. So, stock pickers are still able to find undervalued stocks and benefit from owning them. The second aspect is that of cost and tracking error of the index funds themselves. The whole point of an index fund is that it should be extremely low cost since there is no active management needed but that low cost has not really materialized in the Indian market.

In the Indian market scenario index funds may not be the best option. The basic principle of indexing is - the more the number of stocks comprising an index the better is the diversification and price discovery. 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. In addition, unlike the capital markets in developed countries, Indian markets have not been thoroughly researched and there is enormous scope to beat the market by sound research.

 

The Final Word

Naturally, investment companies are ferociously defending their turf. They make a good deal of money from people who hire active managers. And some managers have been able to add value for investors over and above their costs in expense ratios and fees. In fact, active management proponents argue that it does not make sense to compare index funds to the average fund because it is possible to identify stronger managers up front. You can, for example, restrict your analysis to active fund managers that have a tenure of at least 5 or 10 years and lower expense ratios. And the debate goes on. To determine which approach you prefer, start by assessing your needs and what you are investing for. For example, will capital gains be an issue – will you be investing in or outside a retirement account? And are you prepared to research mutual fund managers to identify which might procure gains over and above their relative index? The bottom line is that investing in index funds has the potential to offer some of the best returns of all fund investing.