FUND FLAVOUR

May 2016

The curious case of Index funds 

The concept of index funds has not worked in India, at least not so far. They are a tremendous success in countries like the USA but not in India. Vanguard in the USA, the largest mutual fund company, has all its products as index funds. Less than 1% of the overall investments in equity mutual funds in India are in index funds. That says it all. The one word that would come to anybody’s mind who is picking mutual funds is ‘performance‘, which again, for index funds, is nothing to write home about. There are several ‘other funds’ that have delivered much better returns. And is that not what we want – more returns? The ‘other funds ‘are the ‘actively managed’ funds compared to the ‘passively managed’ index funds.

If you are new to the jargon, an actively managed fund is the one where the fund manager takes call on what should enter the portfolio, how much, and when. The fund managers call the shots based on several parameters that they have outlined as a part of the investing process. In contrast, a passively managed fund does not need a fund manager. Not literally. Someone does need to take care of the investor’s money. The difference lies in the fact that an index fund simply invests its money in a pre-identified portfolio of stocks. This pre-identified portfolio is usually a popular market index, say for instance, Sensex, Nifty, etc. Sensex, for example, consists of 30 large stocks that are listed on the Bombay Stock Exchange (BSE). Nifty is a collection of 50 such stocks that are listed on the National Stock Exchange (NSE). The 30 of the Sensex or the 50 of the Nifty also have predetermined allocations for each of the stocks. These allocations change over time as markets grow, companies grow – that is a different story though.

An index fund has a simple job 

Just take a look at what the stocks and their respective proportion in the market index are. Invest the money in exactly the same stocks and in exactly the same proportion. After that it has to ensure that the stocks and the proportion remain in tandem with the index. If the proportions change – the fund manager shuffles the portfolio to reflect the new ones. Unlike active fund management, there is no research involved and no extra effort in figuring out which stocks to buy, at what price and when. The success of the index fund is measured in how close it is able to replicate the performance of the underlying index it is copying. This is termed the tracking error. The lower the tracking error, the better the fund is. On the other hand, the active fund’s job is a tough one. It has to beat the underlying benchmark returns. After all that is what you expect, right? Take for example, Franklin India Bluechip Fund. The fund benchmarks itself against the BSE Sensex. The fund will work to deliver a performance better than the BSE Sensex. Hence, it will carry out necessary research and analysis, create investment strategies and decide which stocks and companies make the best investment opportunities. Is it not the precise reason you prefer investing in an active fund like that? Else, you are just better off investing in an index fund.

Is the performance remarkable in any way at all?

There are a variety of benchmarks that the funds use. From the popular ones like BSE Sensex and NSE Nifty to CNX 500 (HDFC Equity), S&P BSE 200 (Birla SL Frontline Equity), CNX Midcap, and S&P BSE 100, though Nifty seems to be a favourite among the funds. In terms of returns, active funds beat their respective benchmarks – that too by quite a margin. On returns basis again, the actively managed funds beat the index funds from the same fund house. The active strategy has emerged a clear winner. All index funds or passively managed funds have a very low expense ratio compared to their actively managed counterparts. It ranges from 0.3% to 1.05%. The low expense ratio is a result of savings on costs of research, analysis and frequent trading of stocks. The turnover ratio of the index funds too is much lower than the active funds, except in some cases. The need to change stocks frequently is just not there and that explains a lower turnover. Whatever one may say, when you select funds, it is the performance that you accord top priority.

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. Also, 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 reasons that make index funds popular in the US may not entirely hold good in India for the following reasons: 

One, the Indian markets lack depth and are not as evolved as the US markets. Hence, there are plenty of opportunities outside of the index that an actively managed fund can tap, as the index does not capture the broad market too well.

Two, the tracking error (and therefore, expenses) in the Indian context is higher as a result of poorly constructed indices and the difficulty involved in tracking them.

Three, the choice of indices is mostly restricted to Nifty and Sensex here. We do not have the variety of indices that US offers.

Four, index funds work well if markets are efficient. Since all information that may affect a stock’s price is already factored in its price, you have very little scope to gain beyond that. However, in the Indian context, there is a larger group of stocks, especially in the mid and small-cap segment, that see constant re-rating and price discoveries as information is not free flowing.

Five, the index stocks picked here have liquidity as a major consideration and therefore, some very fundamentally sound companies may be left out of the index for this reason.

The proof of this is reflected by way of performance of index funds in India when compared with actively managed funds. Over a 5-year period for instance, more than two-thirds of diversified equity funds with a 5-year record comfortably beat the average return of index funds (19.5% compounded annually).

Do index funds make sense?

This does not mean that you should not go for index funds. A good index fund may form part of your core portfolio, along with a few active equity funds with a consistent record (than a flashy one) built around that, based on your requirement and risk appetite.The management of such schemes is easier. No decision is needed on what stocks must be held, for how long, and how much must be invested in each. The fund manager just needs to keep the trading to the tiny level needed to accurately track the index. 

The logical fallout is on cost. Since no research is needed, there is no need for costly analysts. No brainstorming on investment strategy is required either. This translates into low management fees and such funds have low transaction costs. After all, the fund manager will not be actively churning his portfolio. It is buy-and-hold in the true sense. 

So, it is obvious that an index fund can never beat the index. Neither should it do worse. This is contrary to active management, where the fund manager will employ a variety of techniques based on research, sector picking, and market timing to try and beat the market. 

A fund manager brings with him a lot of experience and follows a structured investment approach. He analyses companies, meets managements regularly and based on real-time developments and trend analysis, he can take decisions that help a fund outperform. According to financial planners, actively managed funds have performed better than index funds in the past and they expect that to continue in the near future. A fund manager has the freedom to limit the downside by holding only performing securities, or going into cash if the need warrants. In case of index funds, they fall with the markets, since they have to stay invested in a non performing stock as well. 

However, there are some problems with the way some index funds are actually being run. Some Indian index funds’ performance in the past deviates from the very index they are supposed to be based on. While a small mismatch, called tracking error, is normal, there are funds that have underperformed or outperformed their indices by several percentage points. For an index fund, doing better or worse than the index is definitely not a sign of good management.

Are investors doing the right thing by ignoring index funds?

While it is clear that actively managed funds have outperformed indices over the longer periods, the story is somewhat different over shorter periods. Why should the investor not take the cost advantage if the returns are not higher? In India, the expenses of index funds vary from 0.48% to 1.51% of the money managed. Market regulator Securities and Exchange Board of India has ruled that the maximum expenses charged by equity funds can be up to 2.5%, with the cap on index funds at 1.5%. 

Here are some cases against index funds and some in favour of them. 

Index funds tend to be popular in an efficient market. This theory holds that stock prices generally reflect all that is known about a company. Since the theory states that all markets are efficient, it is impossible for investors to gain above normal returns because all relevant information that may affect a stock’s price is already incorporated within its price. 

So, if all fund managers are investing in the same pool of stocks, it stands to reason that the average fund will do no better than the market’s average performance. By and large, this appears to be true for the US and Europe. Studies have shown that over any given period, a majority of actively managed US funds fail to beat the market. However, this does not appear to be the case in India. 

The move to a more efficient market would require a number of parameters being fulfilled, and they are time-consuming. Greater institutional participation would help the markets. Mutual funds still have a long way to go in adding depth to the market. The greater the participation of funds and wider the coverage, quicker the move towards efficiency. Until then, there will be enough opportunity for an active fund manager to tap and beat the indices. 

Foreign institutional investors have stormed the market over the past few years, but they cannot be considered stable, long-term players. As for the retail investor, he is not really long term and anyway constitutes a small percentage. 

A step towards greater efficiency would be more retail participation, either directly in the stock market or via mutual funds. So, until long-term institutional and retail participation increases tremendously, active fund management will stay crucial. 

At some periods in time, value investing, which involves scouting for cheap and out-of-favour stocks, works. And it is here that a good and active fund manager could bring returns exceeding any index. Indexing only makes sense in particular markets and it is most persuasive among large-cap stocks. 

So, does it mean if you want a portfolio of large-cap stocks you should look at an index fund? Not true. One argument always held in favour of index funds is that they own all the securities in an index, which is a fair and representative sample of the market. But this line of reasoning would hold if the index in question is a well-diversified one, which again may not be the case in India. 

Look at the Sensex—it may be a barometer of the market but it is not a guideline for investing. The Sensex is certainly not diversified enough to capture all sectors. Agriculture, tourism, shipping, aviation and textiles find no place in it. The same is the case with Nifty - shipping, aviation, textiles, consumer durables, agriculture, and tourism are some of the sectors that are missing.

Even if a sector is represented in the Sensex, the selection of stocks need not be the best investment. For instance, the “finance” component is limited to three banks and one financial institution. The financial institution is HDFC, but IDBI, IDFC and PFC are not present. Neither will you find Axis Bank Ltd, Kotak Mahindra Bank Ltd., or Yes Bank Ltd, nor will you come across broking stocks. 

Currently, most index funds track the Sensex or the Nifty, so investors are tied down to large-cap liquid stocks. Because of liquidity issues, a stock may find its way to the Sensex or Nifty, but that does not mean it is the best buy in its field. Smaller companies may provide better investment options. 

But, active fund management does not guarantee higher returns either. Such funds could fall heavily when the market tanks, but if you stay on for the long term in a good fund, you can beat the market. 

An argument in favour of index funds is that it is not easy identifying a good fund manager. And then there is a risk of the fund manager making some really bad calls, resulting in a dismal fund performance. 

There is nothing inherently good or bad about an index fund. But the very reasons that make index funds popular in the US would not hold in India. Consider an index fund if you want a broad exposure to the market, and that too in stocks with a large market value. But even in such a scenario, it would not be wise to put all your money into such a fund. A good way to incorporate a sensible portfolio would be to blend active and passive stock investments. You can take one index fund to form the core of your portfolio but allocate only a small portion of your overall portfolio to it. If its performance disappoints, replace it with another index fund. The balance “active” portion of your portfolio can be distributed in diversified equity funds. If you still have money to spare, you may consider a sector or thematic fund.