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.