FUND FULCRUM

May 2015

Mutual fund industry's asset base has grown around 10% to Rs 11.86 lakh crore at the end of April 2015 from 10.83 lakh crore in March 2015, primarily driven by huge inflows in equity and money market segments. In fact, mutual fund industry's assets under management hit a record Rs 12.02 lakh crore in February 2015 itself. The mutual fund assets base of retail investors rose by a staggering 51% over Rs 2.43 lakh crore at the end of March 2015 as against Rs 1.62 lakh crore held by them in March 2014. These individuals' assets have mainly come from the top 15 cities and are primarily distributor driven. Among the top mutual fund houses, Reliance Mutual Fund saw the highest growth, in the assets under management of retail investors, both in percentage and absolute terms. Reliance Mutual Fund's asset base for retail investors rose 95%, or Rs 13,270 crore, to Rs 27,307 crore at the end of March 2015. This was followed by ICICI Mutual Fund, which saw a growth of 80% in its retail investors AUM to Rs 24,639 crore, Birla Sun Life Mutual Fund (63% to Rs 16,020 crore), HDFC Mutual Fund (46% to Rs 40,272 crore), and UTI Mutual Fund (34% to Rs 35,124 crore). Together, all 44 mutual fund houses manage assets worth nearly Rs 12 lakh crore. Most of the money was pumped in equity-oriented schemes, which was supported by a sharp rally in stock markets. The growth in assets base is in line with the BSE's benchmark Sensex surging by 25% in the past financial year.

Mutual fund managers pumped in over Rs. 7,600 crore in equity markets in April 2015, making it their highest net inflow in more than seven years, mainly on account of positive investor sentiment and the government’s reforms agenda, improved fundamentals of the domestic economy, and increased participation from retail investors. However, the Association of Mutual Funds of India’s decision to put one per cent cap on upfront commission paid to distributors may impact the sector. In comparison, they pulled out Rs. 2,698 crore from the stock markets in April 2014. According to the latest SEBI data, mutual fund managers invested Rs. 7,618 crore in April 2015. This was the highest net inflow in equities since January 2008, when fund managers poured in Rs. 7,703 crore. Besides, fund managers invested Rs. 28,650 crore in debt markets in March 2015. Fund managers have shown interest in equity markets in the past one year. They have pumped in over Rs.40,000 crore in equity markets in 2014-15, making it their first net inflow in six years, for an entire fiscal. Retail investors joined the stock market rally in droves with folios or investor accounts with equity mutual funds increasing by nearly 22 lakh or 7.6% in 2014-15. But larger peers such as HNIs (high net-worth individuals) got more bang for their bucks by making higher investments in equities by cashing in on the rise in markets effectively. The huge inflows also helped the mutual fund industry reach around Rs. 12 lakh crore mark in assets under management at the end of the financial year. Moreover, mutual funds are upbeat about overall inflows in equities and debt markets for the current financial year as well.

Piquant Parade

SEBI has decided to tap social media and other popular internet and mobile platforms to make investors aware about their rights and to safeguard them against possible frauds. SEBI is already present on platforms such as TV, radio, and print newspapers for investor education and awareness programmes. The regulator has also carried out a number of campaigns in various languages including English, Hindi, and regional languages spoken across India. SEBI is now planning to explore various other mediums such as outdoor media, advertising, and social media in the current fiscal 2015-16, to spread investor awareness. In the SMS space, SEBI is specially targeting the schemes where investors are promised doubling of their investments within a few months. Besides, SEBI is continuing its investor education and awareness programmes through newspapers.

BSE announced the introduction of Overnight (Liquid Fund) product on the exchange's Mutual Fund platform, BSE StAR MF - India's largest mutual fund platform. It allows even the smallest investor or a corporate or a trust to invest even for one night in liquid funds anywhere in India. It will be an alternative investment avenue for idle monies by investing in mutual fund liquid schemes for better returns and relatively lower risk. Members should take consent from clients and open a liquid fund account and transact through BSE StAR MF platform. This will result in returns to investors as well as additional service for member brokers. Further to the launch of non-demat transactions on BSE Mutual Fund Platform, the Exchange is now introducing an order entry functionality which shall allow MFI/MFD to place purchase and redemption orders simultaneously in liquid schemes. This facility would be available only for non-demat mode. The bulk order upload facility was made available to MFIs/MFDs with effect from May 18, 2015 for Overnight (Liquid Fund) product.

Regulatory Rigmarole

SEBI Chairman UK Sinha said that the market regulator is working on a blueprint to facilitate electronic KYC or e-KYC in order to expedite the process of client verification and reduce paperwork for intermediaries. e-KYC enables financial institutions to complete KYC process online with direct authorization of clients. By going electronic, KYC can be done on a real time basis. The key objective of e-KYC is to reduce turnaround time and paper work. Typically, KYC Registration Agencies (KRAs) take 8 to 10 days to verify a KYC application. Earlier, SEBI had allowed fund houses to accept e-KYC of UIDAI as a valid proof for the KYC verification. The e-KYC service offered by UIDAI enables individuals to authorize service providers to receive electronic copy of their proof of identity and address. Investors have to authorize intermediaries to access their Aadhaar data through UIDAI system to avail this facility. However, it has not taken off in a big way due to lack of coordination between UIDAI, financial institutions, and KRAs. Banks and insurance companies are already using Aadhaar linked e-KYC service to carry out their KYC verification procedure. However, many banks and insurance companies insist on submitting physical documents even after carrying out eKYC. It remains to be seen whether the new eKYC can address these issues and provide hassle free service to investors.

The Reserve Bank of India’s move to relax norms for Non-Banking Financial Corporations (NBFCs) to sell mutual funds is expected to help the industry expand its footprint in B-15 cities. RBI has come out with a circular in which it has done away with norms like maintaining net owned fund of Rs.100 crore and two years of profitability for distributing mutual fund schemes. With the relaxed norms, NBFCs who stayed away from mutual fund distribution business due to stringent RBI norms may become mutual fund distributors which would mutually benefit both NBFCs and the mutual fund industry. Some NBFCs like India Infoline and L&T Finance are already into mutual fund distribution.

SEBI has done away with the colour coding of mutual fund schemes and has introduced Riskometer which will depict the level of risk through a meter. In 2013, SEBI had introduced colour coding in mutual fund schemes to make investors understand the risk associated with mutual funds. Many financial advisors felt that the colour coding system has only created confusion in the minds of investors. The regulator feels that Riskometer would provide investors an easy understanding of the kind of product/scheme they are investing in and its suitability to them. The decision was taken after consultation with Mutual Fund Advisory Committee (MFAC) of SEBI which has reviewed the system of product labelling in mutual funds. AMCs are supposed to put Riskometer in all their advertisement materials, front page of initial offering application forms, key information memorandum (KIM), scheme information documents (SIDs), and common application forms. The Riskometer will indicate five level of risks – low (principal at low risk), moderately low (principal at moderately low risk, moderate (principal at moderate risk), moderately high (principal at moderately high risk), and high (principal at high risk). This will come into effect from July 1, 2015. However, fund houses are allowed to implement this guideline immediately.

SEBI has asked all existing research analysts in the capital markets to register by May 31, 2015 to continue providing their services, failing which they will face strict penal action. Under the new norms, no person or entity can act as research analyst or research entity without obtaining a registration certificate from SEBI. The Research Analysts Regulations, which came into effect from December 1, 2014, are aimed at safeguarding investors from misleading advice coming from unregulated entities. Under the regulations, foreign entities acting as research analysts for Indian markets or India-listed companies need to tie-up with a registered entity in India, while domestic players are also subjected to strict disclosures and scrutiny. Every individual or entity desiring to function as a research analyst would need to get registered after meeting the prescribed criteria regarding qualifications, capital adequacy, establishment of internal policies and procedures, firewalls against conflict of interest, sufficient and timely disclosures, among others. The regulation also provides for penal actions that SEBI can take against erring research analysts. Such actions would include cancellation of registration, debarment, or penalties similar to any other market intermediary. The framework registers and regulates research analysts as well as those entities that make recommendations related to securities and public offers such as brokerage houses, merchant bankers and proxy advisors. However, Investment Advisers, Credit Rating Agencies, Portfolio Managers, Asset Management Companies, fund managers of Alternative Investment Funds or Venture Capital Funds would not be required to be registered under these regulations.

In its best practice circular issued to AMCs, AMFI has asked fund houses to discontinue bonus options. This has come in the wake of a sudden spurt in the demand for bonus options in equity funds. A few fund houses have introduced bonus options, particularly in arbitrage funds and balanced funds which enable corporates to do bonus stripping for tax planning. Bonus stripping arises on sale or purchase of units of equity mutual funds after/before certain period. It helps in setting off capital loss against capital gain in other capital assets. For instance, if an investor buys mutual fund units under bonus option 91 days prior to record date of bonus and sells the original units subsequently after record date, he/she can set off this loss against any capital gain. Also, the same holds true if investor sells original units after nine months of record date. However, corporates do not prefer the latter option due to its long holding period. The accumulated bonus units are treated as tax free after a year since the arbitrage funds are treated like equity funds for tax treatment. In addition, SEBI rule says that bonus units should not be subject to exit load. The industry body had emphasized that the rule should be followed in true spirit.

Simplifying norms for domestic funds to manage offshore pooled assets, SEBI has dropped the '20-25 rule', which required a minimum of 20 investors and a cap of 25% on investment by an individual, for funds from low-risk foreign investors. As per the existing norms, a fund manager who is managing a domestic scheme is allowed to manage an offshore fund, subject to three specific conditions. The first requires the investment objective and asset allocation of the domestic scheme and of the offshore fund to be the same. The second condition requires at least 70% of the portfolio to be replicated across both the domestic scheme and the offshore fund. The third condition, which was being considered as the most stringent by the industry, requires that the offshore fund should be broad-based with at least 20 investors with no single investor holding more than 25% of the fund corpus. Otherwise, a separate fund manager is required to be appointed for managing an offshore fund. In a notification uploaded on SEBI's website, the regulator said these restrictions would not apply "if the funds managed are of Category I foreign portfolio investors (FPIs) and/or Category II foreign portfolio investors which are appropriately regulated broad based funds." These regulations would be called the Securities and Exchange Board of India (Mutual Funds) Regulations, 2015. SEBI has classified FPIs into three categories, with the first two broadly being low-risk foreign institutions that include sovereign wealth funds, pension funds, banks, mutual funds, insurers, multi-lateral institutions and well-regulated foreign entities, including portfolio managers. The relaxation in the norms have been made keeping in view the challenges faced by the local fund managers in managing offshore pooled assets and the introduction of FPI Regulations which have rationalised  investment routes and monitoring of foreign portfolio investments and also streamlined categories of overseas investors. 

About Rs.1.63 lakh crore of retail money was pumped into the mutual fund industry since the government took charge, up 3 times over the past year. But the mutual fund penetration in the country continues to be relatively low with just 4 crore mutual fund folios, representing 3% of the population. If this is compared with 97 crore telecom subscribers and 21 crore bank accounts, the potential for the mutual fund industry remains big. Asset managed by the mutual fund industry is expected to rise to Rs. 20 lakh crore by 2018, at a 22% CAG and the Indian mutual fund industry is set to achieve an investor base of 10 crore accounts in the next five years.

NFO NEST

May 2015

NFOs on the rise

With rising demand from retail investors for mutual fund schemes, mutual funds have lined up 70 NFOs and have filed draft documents for them with SEBI since the beginning of 2015. Some of these NFOs have already been launched, while other schemes would be opened for subscription as soon as the necessary clearances are obtained. Of these 70 schemes filed, four draft offers have been filed in May 2015 so far, while nine papers were submitted in April, 24 in March, 19 in February, and 13 in January 2015. Manufacturing, retirement, economic recovery, resurgence of the business cycle, and e-commerce are some of the themes that are attracting mutual fund houses like Reliance Mutual Fund, LIC Nomura Mutual Fund, ICICI Prudential Mutual Fund, and SBI Mutual Fund. Besides, a large number of these funds are aimed at investment in equity and equity-related securities. 

SBI Dual Advantage Fund Sr 9

Opens: May 5, 2015

Closes: May 19, 2015

SBI Mutual Fund has unveiled a new fund named as SBI Dual Advantage Fund - Series IX, a close ended hybrid fund. The tenure of the fund is 1111 days from the date of allotment. The primary investment objective of the fund is to generate income by investing in a portfolio of fixed income securities maturing on or before the maturity of the fund. The secondary objective is to generate capital appreciation by investing a portion of the fund’s corpus in equity and equity related instruments. The fund will invest 55%-95% of assets in debt and debt related instruments, invest upto 10% of assets in money market instruments with low to medium risk profile, and invest 5%-35% of assets in equity and equity related instruments including derivatives with high risk profile. Benchmark Index for the fund is CRISIL MIP Blended Fund Index. Rajeev Radhakrishnan will manage the debt portion and Richard D'souza will manage investments in equity and equity related instruments of the fund.

ICICI Prudential Multiple Yield Fund Sr 9

Opens: May 7, 2015

Closes: May 21, 2015

ICICI Prudential Mutual Fund has launched a new fund named as ICICI Prudential Multiple Yield Fund - Series 9, a close ended income fund. The tenure of the plan is 1141 days from the date of allotment of units. 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 65% to 95% of assets in debt securities (including government securities) with low to medium risk profile. It will allocate upto 30% of assets in money market instruments, cash and cash equivalents with low to medium risk profile and it will allocate 5% to 35% of the assets in equity or equity related securities with medium to high risk profile. Of the investments in debt instruments, 84%-89% would be invested in AA rated non-convertible debentures. The benchmark index for the fund will be CRISIL MIP Blended Index. The equity portion will be managed by Vinay Sharma. Rahul Goswami and Chandni Gupta will jointly manage the debt portion of investments under the fund. The investments under the ADRs/GDRs and other foreign securities will be managed by Shalya Shah.

Axis Hybrid Fund Sr 23

Opens: May 8, 2015

Closes: May 21, 2015

Axis Mutual Fund has launched a new fund named as Axis Hybrid Fund Series 23, a 1275 days close ended debt fund. This product is suitable for investors who are seeking capital appreciation while generating income over medium to long term. The fund invests in debt and money market instruments as well as equity and equity related instruments with medium risk. The primary objective is to generate income by investing in high quality fixed income securities that are maturing on or before the maturity of the fund whilst the secondary objective is to generate capital appreciation by investing in equity and equity related instruments. The fund will allocate 70% to 95% of assets in debt instruments including securitized debt with low to medium risk profile, invest upto 25% of assets in money market instruments with low risk profile, and it will allocate 5% to 30% of assets in equity and equity related instruments with high risk profile. Investment in securitized debt will be up to 50% of the net assets of the fund. The fund will not invest in foreign securitized debt. Benchmark Index for the fund is Crisil MIP Blended Fund Index. The fund managers are Devang Shah and Jinesh Gopani.

SBI Equity Savings Fund

Opens: May 11, 2015

Closes: May 25, 2015

SBI Mutual Fund has launched a new fund as SBI Equity Savings Fund, an open ended equity fund. The investment objective of the fund is to generate income by investing in arbitrage opportunities in the cash and derivatives segment of the equity market and capital appreciation through a moderate exposure in equity. The fund will invest 70-30% of assets in equity and equity related instruments including derivatives (out of which, 0-45% will be invested in cash-future arbitrage and 20-50% will be invested in net long equity exposure) with medium to high risk profile and invest 70-30% of assets in debt and money market instruments with low to medium risk profile. The benchmark index for the fund is a combined index - 30% in CNX Nifty and 70% in Crisil Liquid Fund Index. The fund managers are Neeraj Kumar and Ruchit Mehta.

Reliance Equity Savings Fund

Opens: May 12, 2015
Closes: May 26, 2015

Reliance Equity Savings Fund is a balanced offering with conservative equity allocation. The fund seeks to generate income by taking advantage of the arbitrage opportunities that potentially exist between cash and derivatives market and within the derivatives segment along with investments in debt securities and money market instruments. 20-40% is allocated to active equities, 25% to 70% to arbitrage opportunities, and 10% to 35% to fixed income securities. The fund will enjoy growth potential due to moderate exposure to equity, moderate volatility than pure equity funds, and tax efficiency. The fund’s performance is benchmarked against a combined index comprising 40% of CRISIL Liquid Fund Index, 30% of CRISIL Short Term Bond Fund Index, and 30% in CNX Nifty. Sanjay Parekh, Anju Chajjer, and Jahnvee Shah (Overseas Investments) are the fund managers.

India Bulls Make in India – Target Return Fund, Tata Twenty Equity Fund, BOI AXA Capital Protection oriented Fund Series 4, SBI ETF Nifty, ICICI Prudential Wealth Builder Fund Series 1 to 5, LIC Nomura Mutual Fund Retirement Benefit Fund, Pramerica Fixed Duration Fund – Series 19 to 20, Sundaram Value Fund Series I-III, Canara Robeco Capital Protection Oriented Fund – Series 6, 7, and 8, Reliance Constant Maturity Guilt Fund (5 years, 10 years, and 25 years) are expected to be launched in the coming months. 

GEMGAZE
May 2015

Index mutual funds and their brethren, exchange-traded funds, have done better than most actively managed funds over time. There is a place in every portfolio for passively managed index funds or ETFs (or both) and actively managed mutual funds.

The sparkling GEMs among the index funds in India in 2014 have retained their preeminent status in 2015 also.

Goldman Sachs Nifty BeES Gem

Launched in December 2001, Goldman Sachs Nifty BeES, the first ETF in India, has an AUM of Rs 889 crore. Large caps rule the roost with 99.53% of the portfolio in large cap stocks. 99.53% of the assets are in equities. 60.5% of the assets are in the top three sectors, finance, technology, and energy. The one-year return of the fund is 22.34%, slightly trailing the category average of 25.43%. 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 102%.

ICICI Prudential Index Fund Gem 

The AUM of ICICI Prudential Index Fund, launched in February 2002, which has been hovering around Rs 73 crore last year, has reached Rs 91 crore at present. Large caps constitute 99.53% of the portfolio, with 98.79% of the assets in equity. The top three sectors, finance, technology, and energy, account for 54.89% of the portfolio. The one-year return of the fund is 24.09%, less than the category average of 27.34%. The returns of the fund are benchmarked against the CNX Nifty. The expense ratio of the fund is 0.76% and the portfolio turnover ratio is 11%.

Franklin India Index Fund Gem

The AUM of Franklin India Index Fund, launched in July 2000, is Rs 206 crores. Large caps constitute 99.53% of the portfolio, with 99.36% of the assets in equity. The top three sectors, finance, technology, and energy account for 60.15% of the portfolio. The one-year return of the fund is 23.35%, as against the category average of 27.34%. 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 29%.

Principal Index Fund Gem

Launched in June 1999, the AUM of Franklin India Index Fund is Rs. 19 crores. Large caps constitute 99.52% of the portfolio, with 99.55% of the assets in equity. The top three sectors, finance, technology, and energy account for 60.48% of the portfolio. The one-year return of the fund is 22.97%, as against the category average of 27.34%. 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 97%.

HDFC Index Sensex Plus Fund Gem

Launched in July 2002, HDFC Index Sensex Plus Fund sports an AUM of Rs 126 crore. This fund has always had a large-cap tilt with 88.92% in large caps and 98.25% in equity. The one-year return of the fund is 26.08% as against the category average of 27.34%. The top three sectors of the fund are finance, technology, and energy. 55.81% 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 21%.

UTI Nifty Index Fund Gem

The AUM of UTI Nifty Index Fund is Rs 236 crores. This open-ended passive fund was created by merging UTI Sunder and UTI Master Index fund on March 14, 2012. Large caps constitute 99.52% of the portfolio, with 99.06% of the assets in equity. The top three sectors, finance, technology, and energy account for 60.19% of the portfolio. The one-year return of the fund is 23.99%, as against the category average of 27.41%. The returns of the fund are benchmarked against CNX Nifty. The expense ratio of the fund is 1.06% and the portfolio turnover ratio is 62%.

Tata Index Nifty Fund Gem

Launched in February 2003, the AUM of Tata Index Nifty Fund is Rs 9 crores. Large caps constitute 99.5% of the portfolio, with 100% of the assets in equity. The top three sectors, finance, technology, and energy, account for 70.94% of the portfolio. The one-year return of the fund is 22.66% as against the category average of 27.41%. 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 8%.

FUND FLAVOUR

 

May 2015

In order to truly understand index funds, we need to first take a step backwards and discuss what they are ‘cloning’ – stock market indices. Stock market indices measure the composite value of a group of stocks. Indices can be chosen through a set of rules or hand selected by committees. Some popular indices are the Sensex and the Nifty.

What are index funds?

Index mutual funds are a type of mutual fund that attempts to mimic the performance of a stock market index. Like a mutual fund, the value of index funds are based on the net asset value of all the stocks they have invested in. 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. For example, if Reliance Industries has a weightage of 10% in an index, a fund based on the index would also allocate 10% of its portfolio to the stock. Rather than its holdings being regularly bought and sold through managed trades, index funds periodically change investments based on a set of rules or infrequent committee selected changes. A lot of them take out the human decision element completely. An index fund follows a passive investing strategy called indexing. It involves tracking an index say for example, the Sensex or the Nifty and builds a portfolio with the same stocks in the same proportions as the index. The fund makes no effort to beat the index and in fact it merely tries to earn the same return. 

The pros…

Proponents of index funds point towards data that shows that they consistently outperform their actively managed mutual fund peers due to the following reasons:

No fund manager risk: This strategy of building an equity fund portfolio, called passive fund management, nullifies the risk associated with a fund manager, whether it is the possibility of quitting the fund or taking wrong investment calls. Index funds are independent of the competence of a fund manager, his longevity, or his character. Index funds are ideal for investors who prefer to take only market risk and not a fund manager risk.

Lesser portfolio churn: As the portfolio is based on a particular index, there is less churning of the portfolio, thus saving on the brokerage and transaction cost.

Low expense ratio: With limited role of fund managers, the fund management charges are also lower in index funds as a result of which the expense ratio is lower than that of actively managed funds. The average expense ratio of actively-managed fund is 2-2.5%, while it is 1-1.5% in the case of index funds.

Tax efficiency: Broad index funds generally do not trade as much as actively managed funds might, so they are typically generating less taxable income, which reduces the drag on your investments.

Suited to efficient markets:  As markets become more efficient, it becomes harder for fund managers to beat their benchmarks. Passive funds progressively become the preferred investment vehicle in such markets. In the Indian market's most efficient segment, the large-cap space (funds with more than 80% allocation to large-cap stocks), passive funds have a significant presence.

Automatic clean-up of portfolio: Due to the manner in which indices are constituted, an automatic clean-up of portfolio takes place in passive funds. These indices own the outperformers and remove the underperformers. They keep changing since yesterday's blue chips may no longer be so today. When people opt for passive funds, they do not need to worry about being invested in laggards.

No security-specific risk: Since you invest in a basket of securities, they allow you to take a bet on the broad market (or asset class). The security-specific risk is reduced as a single stock or bond has a limited exposure in an index and can cause only limited damage.

Diversification in a single package: Contrary to much popular opinion, investors benefit from owning more stocks, not fewer. By including all the stocks in an asset class, index funds give that advantage to their unit-holders. Studies show that owning more stocks will probably increase your return, and it will certainly reduce your level of risk.

Control of 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.

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. One reason is to preserve buying power to purchase “hot” stocks; another is to cover redemptions of unit-holders who want to bail out after market declines. That cash can cost unit-holders 0.5% a year in return, with no corresponding benefit. This does not happen in index funds.

Easier to manage portfolio: Since investors do not have to bother about the performance of specific funds, all they have to do is rebalance their portfolios periodically.

Need not monitor 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 performance with that of its index; they should be extremely close.

Easy to choose index funds: Pick your asset class, then find the most efficient index fund that follows it. If you are choosing actively managed funds, each asset class may force you to choose among hundreds of funds whose management, track records, and portfolios are constantly changing.

…and cons

No outperformance: A small set of active fund managers will always outperform the indices. If you have invested in passive funds, do not pay too much attention to the active funds that have outperformed in a given year. Remember that the probability of correctly predicting next year's winners year after year is very small.

Lack of options: 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). In the international space, while you have a fund based on the NASDAQ—which usually has smaller, fast-growing, technology-oriented companies—a passive fund based on the US S&P 500 Index—which includes America's corporate heavyweights—is not yet 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 initial inertia

Index funds first came into being in the United States in the 1970s. In the US, research established the efficient markets concept which says that stocks are mostly priced accurately and that it is not possible to beat the market in a systematic way. Though a few actively managed mutual funds may beat the market for a while, it is very rare for active funds to beat the market in the long run. 

Indices are comprised of hundreds of securities. Keeping track of their daily pricing is an enormous feat. But to offer this 'basket' of securities to investors, additional calculations would need to be added to the equation. Daily cash flows into and out of a fund are difficult to manage in a cost effective way. Actively managed funds passed the cost of these complicated transactions on to their unit-holders. It was not until 1975 that computers were developed with enough sophistication to accomplish the task. The advent of more computing power did give the index fund the potential to track the market. But something else happened that year. Until 1975, mutual fund managers were not allowed to negotiate the cost of trading. This fixed commission system was deregulated allowing fund managers to lower their costs to investors. Deregulation also allowed index funds to be sold without forcing the investor to use a commission-based broker. The last and no less formidable obstacle was overcoming the hubris of mutual funds. They believed that they could beat the market. What they worried most about was the possibility that they might not be smart enough to actually do so. And John Bogle jumped at the opportunity to prove those fears were well-founded.

The first index fund was created in 1975 by Vanguard founder John Bogle. Some believe that Bogle’s philosophy was based on the book A Random Walk Down Wall Street by Burton Malkiel, which argued that one cannot consistently outperform the market averages. To this date, Bogle (now retired from Vanguard) and Vanguard remain strong advocates for investing in index funds, and Vanguard is now the second largest mutual fund company in the world.

Index funds in the context of India

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. There are a lot of really well-managed and profitable companies which are not in the Nifty or the Sensex due to which a non-Nifty or non-Sensex based mutual fund can invest outside the index and easily generate returns far superior than the index. 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. So for a serious index investor in India, the only way to invest in the index at lower cost would be to take the ETF route.

From a list of Nifty Index funds and Sensex Index funds  it can be said that a lot of them charge in excess of 1% recurring expenses and that is simply too high for an index fund. Since then there have been funds that charge much lower expenses, most notably the IIFL Nifty ETF that has an expense ratio of 0.25%, which is the lowest of any index ETF till date. The biggest Nifty ETF – Goldman Sachs Nifty BeES ETF is also a low cost ETF which has expenses of about 0.50% and has been around for a decade now, but as a category – the low cost has still not become a norm, and that makes a difference to the returns. So, the two main benefits of investing in index funds – which is low costs and doing better than active funds have been more or less absent in India so far and it is hard to say why. People who want the benefit of passive investing feel that by creating a SIP in an active mutual fund – you enjoy the same kind of benefit and the past returns show that it has been beneficial as well.

Are index funds right for you?

Because of their low costs, broader diversification, and tax efficiency, index funds could be appropriate for any portion of your portfolio. Index fund returns keep getting better the longer you hold them. This is because low-cost index funds give you more of the market’s return and many actively-managed funds eventually go under. A combination of cost savings and longevity help index fund returns float to the top in rankings.