FUND FULCRUM (Contd.)

May 2017

The fourth largest fund house in terms of AUM, Birla Sun Life has received highest net inflows of close to Rs.40,000 crore in April-December 2016, according to the latest SEBI data. The inflows increased by 202% or by Rs.26,609 crore compared to the corresponding period last year. HDFC Mutual Fund closely followed Birla Sun Life Mutual Fund with inflows of Rs.37,619 crore in April-December 2016, an increase of Rs.23,256 crore or 162% in a year. In terms of percentage, DHFL Pramerica Mutual Fund witnessed the highest growth. The net inflows of the fund house grew from just Rs.19 crore to Rs.1500 crore in April-December 2016. Last year has been a year of transformation. During this time, DHFL Pramerica AMC acquired Deutsche’s Indian asset management business after which they have started building their business. SEBI data shows that top ten fund houses in terms of AUM witnessed inflows during April-December 2016. Other than that, Invesco Mutual Fund and BOI AXA Mutual Fund also witnessed a substantial rise in inflows. Emerging fund houses witnessed net outflows in April-December 2016 with Edelweiss Mutual Fund and Taurus Mutual Fund recording the highest net outflows among emerging fund houses. Edelweiss Mutual Fund saw an outflow of Rs.1,049 crore during Apr-Dec, which led to a 227.46% decline in the net inflows from the previous year. Edelweiss Mutual Fund acquired JP Morgan Mutual Fund last year. Taurus Mutual Fund saw outflow of Rs.985 crore. PPFAS Mutual Fund, IIFL Mutual Fund, HSBC Mutual Fund, Shriram Mutual Fund and Sahara Mutual Fund were the other emerging fund houses that witnessed outflows during the same period.

Regulatory Rigmarole

Investors will be permitted to purchase mutual funds worth up to Rs 50,000 through digital wallets. Investments up to Rs 50,000 per mutual fund per financial year can be made using e-wallets, while redemptions of such investments can be made only to the bank account of a unit holder. E-wallet issuers would not be permitted to offer any incentive such as cash back, directly or indirectly, for investing in mutual fund scheme through them. Besides, the e-wallet's balance loaded through cash or debit card or net banking can only be used for subscription to mutual funds schemes. Balance loaded through credit card, cash back, promotional schemes would not be allowed for subscription to mutual funds. The limit of Rs 50,000 would be an umbrella limit for investment by an investor through e-wallet and/or cash, per mutual fund. Besides, mutual funds and asset management companies have been allowed to provide instant online access facility to resident individual investors in liquid schemes. In this case, the limit would be up to Rs 50,000 or 90 percent of folio value, whichever is lower. For providing such facility AMCs would not be allowed to borrow. Liquidity is to be provided out of the available funds from the scheme and AMCs to put in place a mechanism to meet the liquidity demands. This facility can also be used for investment in mutual funds through tie-ups with payments banks provided necessary approvals are taken from the RBI. Currently, any scheme providing the facility would reduce the limit to Rs 50,000 immediately.

With an aim to bring in greater transparency in dealings of mutual funds, markets regulator SEBI asked mutual fund houses to disclose to investors the remuneration of employees earning Rs 1 crore in a financial year. Like listed companies, mutual fund houses will also have to disclose the annual salary of chief executive officer (CEO), chief investment officer (CIO), chief operating officer (COO) and any other top official and also the ratio of CEO's remuneration to median employee salary. Besides, mutual fund's total Average Assets Under Management (AAUM), as well as debt and equity AAUM and rate of growth over last three years would have to be disclosed. The fund houses will have to disclose these information within one month from the end of a financial year starting with 2016-17. To promote transparency in remuneration policies so that top executive remuneration is aligned with the interest of investors, fund houses will have to make the disclosures pertaining to a financial year on its website under a separate head 'remuneration'. Under this, mutual fund houses will have to disclose name, designation and remuneration of CEO, CIO and COO as well as salaries drawn by top ten employees in terms of remuneration for that financial year. Besides, name, designation and remuneration of every employee whose total pay package is equal to or more than Rs 1.02 crore for that financial year need to be disclosed. Salary details of part-time employees, who received at least Rs 8.5 lakh per month during their stint with the company should also be disclosed.

Complying with the latest Finance Ministry circular on FATCA, AMFI has asked fund houses to freeze non-FATCA compliant accounts with immediate effect. This means, non-FATCA compliant investors cannot execute fresh mutual fund transactions. Earlier, the ministry had directed fund houses to comply with FATCA regulations before April 30, 2017. Foreign Account Tax Compliance Act (FATCA) is an anti-tax evasion law under which fund houses are required to report information on US investors to US IRS (Internal Revenue Service) through CBDT. India agreed ‘in substance’ to FATCA by signing an Intergovernmental Agreement Model 1 (IGA-1) with the US, in effect from July 9, 2015. Simply put, the legislation is meant to prevent wealthy US individuals from parking money overseas to avoid paying taxes. In a communication sent to fund houses, AMFI has asked them not to entertain any financial service request such as redemption, lump-sum investment, etc. from non-FATCA compliant investors. AMFI has, however, directed fund houses to allow such investors to continue with their SIP/SWP/STP until expiry. Such investors cannot redeem their mutual fund investments. Similarly, fund houses can process payments arising out of dividend or maturity of close-end funds, AMFI added. In addition, AMFI clarified that fund houses can process non-financial service requests such as registration or change in nomination, bank account, mobile number and email address of non-FATCA compliant investors. Non-FATCA compliant investors can still update their FATCA information through all registrar and transfer agents by submitting a self-declaration form. Investors who have invested in mutual funds after August 31, 2015 are FATCA compliant since fund houses insist investors submit a self-declaration form before initiating any transaction. The problem is with the accounts opened between July 1, 2014 and August 31, 2015. The move is therefore likely to affect large fund houses (top 15 AMCs in terms of AUM) as they have old assets.

The Securities and Exchange Board of India has requested the Finance Ministry to allow bank KYC as proof for making mutual fund investments. A slew of fund houses had requested SEBI Chief to simplify onboarding of investors by allowing bank KYC and Aadhaar as valid identification to invest in mutual funds. Currently, a PAN card is required, along with an address proof and a cancelled cheque to be KYC-compliant. Similarly, for opening a bank account, PAN card and address proof is required. But, Aadhar card holders have already undergone In Person Verification (IPV). So, there is no need to do KYC and IPV again. At present, a new investor has to wait for nearly a week after submitting the above documents to invest more than Rs 50,000 in mutual funds. The ones who invest in mutual funds have a bank account so allowing bank KYC and Aadhaar as valid proof of KYC and IPV would make KYC procedure smoother and easier, which will reduce turnaround time to onboard a new client. Although the government had launched Central KYC last year to do away with the requirement of doing multiple KYC, it will take time to get operational.

SEBI has allowed mutual funds, AIFs and PMS to invest in securities of International Financial Services Centres (IFSCs). An IFSC does not follow domestic economic law; instead, they follow international practices. IFSCs deal with flows of finance, financial products and services across borders. Companies setting up offices in IFSCs cannot deal in local currency. In addition, IFSCs can provide fund raising services for individuals, corporations and governments and wealth management services to foreign investors. In India, Gandhinagar has one IFSC called Gujarat International Finance Tec-City (GIFT). Fund houses can now invest in securities, which are listed in IFSCs, securities issued by them and securities issued by the companies incorporated in India. Experts say that the move may help AMCs. Only established companies set up offices in FPSCs. In future, stock exchanges having presence in IFSCs may list companies having businesses in IFSCs helping AMCs to invest in such companies to diversify the scope of investments. Currently, fund houses can accept investments from foreign investors through FPI route. In addition, they can invest in securities of foreign companies but such scrips are treated as debt securities for taxation purpose. 

There is good news for the mutual fund industry. The participation of retail investors in the mutual fund industry has increased by 50% to reach Rs.9.28 lakh crore. Retail AUM now constituted almost half of the overall AUM of Rs.19.28 lakh crore. Rising retail AUM is a healthy sign for the industry as retail investors stay put for long term compared to institutional investors. Of the Rs.9.28 lakh crore retail AUM, Rs.2.33 lakh crore or 25% came from B15 cities as on April 2017. Another good sign for the industry is increasing participation of retail investors in equity funds. The AUM in retail investors in equity funds increased by 50% year-on-year to Rs.6.62 lakh crore in April 2017 shows AMFI data. With this, retail equity AUM now constitutes 94% of the overall equity AUM of the mutual fund industry. Equity funds have done well over the years. In addition, people are confident because of GST and other economic reforms.  The confidence of the retail investors can be seen from the fact that a lot of investments is coming through SIPs in equity funds. The investor appetite for equities can also be derived from the fact that the number of folios under equity schemes increased by 17% from 3.87 crore folios in April 2016 to 4.51 crore in April 2017. Overall, the retail folios for the month stood at 5.46 crore.

FUND FULCRUM

May 2017

The new financial year started on a positive note for the Indian mutual fund industry as it came within striking distance of the Rs. 20 lakh crore milestone and could touch the magic figure in June 2017 itself if industry assets grow by another 4%. According to data from Association of Mutual Funds in India (AMFI), the Assets Under Management (AUM) of the Indian mutual fund industry grew 9.8% from Rs. 17.54 lakh crore in March 2017 to Rs. 19.26 lakh crore in April 2017. Of the Rs. 1.5 lakh crore that investors pumped in different categories in April 2017, liquid, income and equity funds (including Equity Linked Savings Schemes or ELSS) saw the highest inflows. The three categories saw net inflows of Rs. 0.99 lakh crore, Rs. 0.35 lakh crore and Rs. 0.09 lakh crore, respectively. Equity funds also got support from the broader market rally as BSE Sensex touched an all-time high of 30,000 in April 2017. Secular growth of Systematic Investment Plans (SIPs) and investor awareness campaigns have been the two mainstays of the Indian mutual fund industry in the recent past.

Mutual fund houses added over 77 lakh investor accounts in 2016-17, taking the total tally to a record 5.54 crore on growing interest of retail as well as HNI investors. In comparison, 59 lakh folios were added in the preceding fiscal. In the last two years, investor accounts have increased following robust contribution from smaller towns. Folios are numbers designated to individual investor accounts, though an investor can have multiple ones. According to AMFI data on total investor accounts with 42 active fund houses, the number of folios rose to a record 5,53,99,631 at the end of March 2017, from 4,76,63,024 at the end of March 2016, a gain of 16% or 77.37 lakh. Growing participation from retail as well as HNI categories have helped in raising overall investor accounts. Individually, HNIs' folios rose by 39% to 25.12 lakh. Last fiscal saw a surge in the number of retail investor accounts, which comprises equity, equity-linked saving schemes and balanced categories, by 15% to 5.23 crore. The fiscal year 2016-17 saw retail and HNI folios touching the highs of March 2010. These folios took almost six years to get back to the March 2010 levels of 4.76 crore. They crossed this mark in June 2016 and as of March 2017 stood at 5.48 crore.

Mutual fund managers purchased stocks worth close to Rs 10,000 crore in April 2017, making it the highest investment in five months, on sustained participation by retail investors. This comes on top of over Rs 51,000 crore investment in stocks in the entire 2016-17 financial year. Fund houses are upbeat about the industry's performance in the ongoing fiscal while expecting investment from new investors to fuel the growth of the sector. As per data released by the Securities and Exchange Board of India (SEBI), mutual fund managers invested a net sum of Rs 9,918 crore in stock markets in April 2017, much higher than the Rs 4,191 crore infused in March 2017. This was the highest infusion by fund managers since November 2016, when they had invested a net sum of Rs 13,775 crore in stock markets. Apart from equities, fund managers invested a staggering Rs 58,000 crore in debt markets in April 2017.

HDFC Mutual Fund is still the largest fund house in terms of equity AUM. The fund house lost its top position as the mutual fund house managing the largest AUM last year to ICICI Prudential Mutual Fund but it turned out to be a winner in the equity AUM category. HDFC Mutual Fund manages a total AUM of Rs.2.37 lakh crore of which 40% of the assets is in equity funds. Equity AUM of the fund house has increased by over 45% from Rs. 63,900 crore in FY 2015-16 to Rs. 93,000 crore in FY 2016-17. This growth can be attributed to the performance of their funds and strong distribution network of the fund house. ICICI Prudential Mutual Fund which currently manages the largest AUM in the industry stood at the second position with an equity AUM of Rs. 89,377 crore. Similarly, Reliance Mutual Fund stood at third position with equity AUM of close to Rs.67,000 crore. In terms of percentage, SBI Mutual Fund recorded highest equity AUM growth last fiscal. The fund house witnessed 92% growth in equity AUM from Rs.34,165 crore to Rs.65,744 crore. This could be partially due to inflows in ETFs because of EPFO’s contribution. Schemes whose assets have increased manifold in the last year include SBI Bluechip Fund and SBI Magnum Taxgain Scheme. In fact, the AUM of SBI Bluechip has increased from nearly Rs.5,000 crore in March 2016 to Rs.13,000 crore in March 2017. Overall, the total equity AUM of the top 10 fund houses stood at Rs.5.16 lakh crore as on March 2017. Interestingly, this indicates that the top 10 fund houses account for nearly 82% of the total equity AUM in the industry. The total equity AUM of the industry grew by 46% to Rs.6,30  lakh crore as on March 31, 2017 as against Rs. 4.31 lakh crore in the previous corresponding year. Fund houses earn from the total expense ratio charged on schemes. Equity funds, which charge higher expenses as compared to debt funds, are more profitable for fund houses. It saw net inflows of over Rs. 3.50 lakh crore of which Rs. 1.34 lakh crore was from equity funds, including ELSS, balanced funds and ETFs, which helped AMCs grow their PAT.

Piquant Parade

India Post Payments Bank (IPPB) will start selling mutual funds and insurance products of other companies by early 2018 and is open only to "non- exclusive" tie-ups. IPPB will start full-fledged operations in every district of the country by September 2017. The bank had launched its pilot project with a branch each in Raipur and Ranchi on January 30, 2017. IPPB will curate third party products before selling it so as to ensure that it is simple for customers. In addition, there would not be any training of staff necessary as no individual product of any specific company is to be sold. As per RBI norms, Payments banks have to focus on providing basic financial services, including social security and utility bill payments, remittance functions, and can mobilise deposits of up to Rs 1 lakh. In addition, they can distribute insurance, mutual funds and pension products, and act as business correspondent for other banks for credit products. As many as 100 entities including IDBI Bank, HSBC, Axis Bank, Deutsche Bank, Barclays Bank, Citibank, SBI and LIC have evinced interest in partnering with IPPB for various functions given the unmatched rural reach India Post has. The list of insurance companies which has approached the payments bank include HDFC Life, ICICI Prudential, Max Life Insurance and Bajaj Allianz Life. As part of its expansion drive, IPPB plans to open 650 new branches by September 2017. The Postal Department at present has a network of 1.55 lakh post offices and the new branches will be set up within them.

Private equity firms like Blackstone and General Atlantic have reportedly been eyeing a majority stake in Karvy Computershare. Both the PE firms are in separate talks to buy close to 74% stake in Karvy Computershare for roughly Rs.2,100 crore. While Australian R&T Computershare, which has 50% stake in the company, may exit the business by selling its entire stake, Karvy group is likely to offload its 24% stake in the company. In 2013, the National Stock Exchange bought 45% in CAMS from global buyout fund Advent International. Currently, Karvy Computershare services 25 fund houses.

To be continued…

NFO NEST

May 2017

Closed-end NFOs rule the roost in the May 2017 NFONEST.

Sundaram Value Fund – Series VIII

Opens: May 2, 2017

Closes: May 16, 2017

Sundaram Mutual Fund has launched a new fund named as Sundaram Value Fund Series - VIII, a close ended equity fund with the duration of 4 years from the date of allotment of units. The objective of the fund is to provide capital appreciation by investing in a well-diversified portfolio of stocks through fundamental analysis. The fund will allocate up to 80% of assets in equity and equity related securities with high risk profile and invest up to 20% of assets in fixed income and money market instruments with low to medium risk profile. The performance of the fund will be benchmarked against S&P BSE 500 Index. The fund managers are S. Krishnakumar, Madanagopal Ramu (Co-Fund Manager - Equity) and Dwjendra Srivastava (Fixed Income).

Axis Equity Advantage Fund – Series I

Opens: May 5, 2017

Closes: May 19, 2017

Axis Mutual Fund has launched a new fund named as Axis Equity Advantage Fund - Series 1, a close ended equity fund. The fund will mature 1590 days from the date of allotment of units. The primary objective is to generate capital appreciation over medium to long-term from a diversified portfolio of predominantly equity and equity related instruments. It also aims to manage risk through use of active hedging techniques. The fund will allocate 65% to 100% of assets in equity and equity related instruments with high risk profile and invest up to 35% in debt and money market instruments with low to medium risk profile. Benchmark Index for the fund is a combination of Nifty 50 Index (75%) and Crisil Composite Bond Fund Index (25%). The fund managers are Shreyash Devalkar and Ashwin Patni.

SBI Dual Advantage Fund – Series XXII

Opens: May 8, 2017

Closes: May 22, 2017

SBI Mutual Fund has unveiled a new fund named as SBI Dual Advantage Fund - Series XXII, a close ended hybrid fund. The tenure of the fund is 1100 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 corpus in equity and equity related instruments. The fund will invest 55%-95% of assets in debt and debt related instruments, invest up to 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 shall manage debt portion and Ruchit Mehta shall manage investments in equity and equity related instruments of the fund.

ICICI Prudential Capital Protection Oriented Fund – Series XII

Opens: May 9, 2017

Closes: May 23, 2017

ICICI Prudential Mutual Fund has launched a new close ended capital protection fund named “ICICI Prudential Capital Protection Oriented Fund - Series XII - Plan A 1168 Days” with maturity period of 1168 days from the date of allotment. The asset allocation of the fund will be in such a way that the objective of the fund to protect capital will be met by investing a portion of the portfolio in highest rated debt securities and money market instruments. Hence, the fund will allocate 65 to 100 per cent of asset in debt instruments and money market instruments and 0 to 35 per cent of asset in equity and equity related instruments. The performance of the fund will be benchmarked against Crisil Composite Bond Fund Index (85 per cent) and CNX Nifty (15 per cent). Rahul Goswami, Ihab Dalwai, Vinay Sharma and Chandini Gupta will be the fund managers.

Sundaram Select Microcap Fund – Series XV

Opens: May 10, 2017

Closes: May 24, 2017

Sundaram Mutual Fund has launched a new fund named as Sundaram Select Micro Cap - Series XV, a closed-end equity fund. The tenure of the fund is 5 years from the date of allotment of units. The objective of the fund would be to generate capital appreciation by investing predominantly in equity/equity-related instruments of companies that can be termed as micro-caps. The fund will invest 80%-100% in equity and equity related securities of companies of micro-caps, invest up to 20% of assets in other equity (including investment in derivatives of large caps) with high risk profile and invest up to 20% of assets in fixed income and money market securities with low to medium risk profile. The performance of the fund will be benchmarked against S&P BSE Small Cap Index. The fund managers are S Krishnakumar and Dwijendra Srivastava.

Canara Robeco Capital Protection Oriented Fund – Series 8

Opens: May 12, 2017

Closes: May 26, 2017

Canara Robeco Mutual Fund has launched a new fund named as Canara Robeco Capital Protection Oriented Fund - Series 8, a close ended capital protection oriented fund. The tenure of the fund is 1140 days from the date of allotment. The investment objective of the fund is to seek capital protection by investing in fixed income securities maturing on or before the maturity of the fund and seeking capital appreciation by investing in equity and equity related instruments. The fund would allocate 70% to 100% of assets in Indian debt instruments and money market instruments with low to medium risk profile and up to 30% of assets in equity and equity related instruments with medium to high risk profile. Benchmark index for the fund is CRISIL MIP Blended Fund Index. The fund managers will be Shridatta Bhandwaldar and Suman Prasad.

GEMGAZE

May 2017

All the GEMs from the 2016 GEMGAZE but Tata Index Nifty Fund have performed reasonably well through thick and thin and figure prominently in the 2017 GEMGAZE too. 

Reliance ETF Nifty BeES Gem

Incorporated in December 2001, Reliance ETF Nifty BeES (formerly known as Goldman Sacs Nifty ETF Fund) has an AUM of Rs 912 crore. The one-year return of the fund is 22.5% as against the category average returns of 24.83%.  The top five stocks constitute 34.6% of the assets of the fund. The top three sectors finance, energy, and technology constitute 60.87% of the assets of the fund. The expense ratio of the fund is 0.49% and the turnover ratio is 62%. The fund is benchmarked against the Nifty 50. The fund is efficiently managed by Mr. Payal Kaipunjal since May 2014.

ICICI Prudential Index Fund Gem

The Rs 260 crore ICICI Prudential Index Fund, incorporated in February 2002, has earned a one-year return of 21.71% slightly trailing the category average return of 24.83%. Top five holdings constitute 33.87% of the portfolio. 60.67% of the assets are invested in finance, energy and technology, the top three sectors. While the portfolio turnover ratio is very high at 106%, the expense ratio is low at 0.93%. The fund is managed by Kayzad Eghlim since August 2009.

Franklin India Index Fund Gem

Franklin India Index Fund, incorporated in August 2000, has an AUM of Rs 241 crore. Its one-year return is 21.42%, slightly lower than the category average return of 24.83%. Top five holdings constitute 32.98% of the portfolio. 58.05% of the assets are invested in finance, energy and technology, the top three sectors. The expense ratio of the fund is 1.06%. The fund is benchmarked against the Nifty 50. The fund is managed by Varun Sharma since November 2015.

HDFC Index Sensex Plus Fund Gem

HDFC Index Sensex Plus Fund is a fifteen-year old fund with an AUM of Rs 108 crore. Its one-year return is 23.12%, almost nearing the category average of 23.47. Top five holdings constitute 37.7% of the portfolio. 56.24% of the assets are invested in finance, energy and technology, the top three sectors. The expense ratio of the fund as well as the turnover ratio is low at 1% and 7% respectively. The fund is benchmarked against the S&P BSE Sensex. The fund has been managed by Krishan Kumar Daga since October 2015.

UTI Nifty Index Fund Gem

Incorporated in March 2000, UTI Nifty Index Fund has an AUM of Rs 527 crore. The one-year return of the fund is 20.91% trailing the category average of 23.47%.  Top five holdings constitute 32.8% of the portfolio. 57.68% of the assets are invested in finance, energy and technology, the top three sectors. The portfolio turnover ratio is a moderate 49% and the expense ratio is very low at 02%. The fund is benchmarked against the Nifty 50. The fund is managed by Kaushik Basu since July 2011.

FUND FLAVOUR

May 2017

An index fund is a collective investment scheme that aims to replicate the movements of an index of a specific financial market. Index funds today are a source of investment for investors looking at a long term, less risky form of investment. The success of index funds depends on their low volatility and therefore the choice of the index. An index is a group of securities that represents a particular segment of the market (stock market, bond market, etc.). Among the most well-known companies that develop market indexes internationally are Standard & Poor's and Dow Jones. Index funds will hold almost all of the securities in the same proportion as its respective index. Index funds can be structured as a mutual fund, an exchange-traded fund, or a unit investment trust. Since the index fund directly tracks the index composition, it does not involve active fund management. The lack of active management generally gives the advantage of lower fees (which otherwise reduce the investor's return). The difference between the index performance and the fund performance is called the "tracking error", or, colloquially, "jitter". This is usually because of the administration fees or time delays in tracking.

Index funds provide low-cost access for investors to buy and hold leading stocks. And holding them is a key strategy. In the words of Bogle, the pioneer of index funds “Time is your friend; impulse is your enemy”.

Weighing the balance…

1. Cost of Investments - The cost associated with the management of an index fund is much lesser than that of a managed fund, which requires active trading (churn). Hence, index funds save on expenses like brokerage and transaction costs. Moreover, since a fund manager is not involved, the fund management charges are lower and hence the expense ratio is lower. The average expense ratio of actively managed fund is 2-2.5%, while it is 1-1.5% in the case of index funds.
2. Management Style - An experienced fund manager, following a structured investment approach is like a visionary leader marshalling his resources. Based on the real-time developments and trend analysis, he or she can take strategic decisions that can lead the fund towards outperformance. This aspect is missing for a passive fund.
3. Limited downside - Unlike index funds that mirror the market, managed funds invest in handpicked securities. A fund manager has the freedom to limit the downside by holding only performing securities. In the case of index funds, they fall as the market falls. They are vulnerable to market volatility and systemic risk. For example, during a severe economic recession, an index fund’s value may drop considerably.
4. Fund Manager Risk - There is a chance your fund manager might make a poor decision. He might be subject to some form of systemic pressures or might end-up investing in an underperforming stock. There is a chance of him quitting the fund too. These situations can affect your investments. Index funds negate this risk by passively investing only in securities that represent a particular index.
5. Less risky - Index funds are less risky than actively managed mutual funds, since they are constructed to mirror the market, rather than outperform it. In addition, since market indexes are highly diversified in nature, investing in index funds is far less risky than purchasing one type of security or shares in a few firms.

6. Traded on exchanges - Most mutual funds can be traded only on NAV (i.e. the net asset value declared at the end of the day). However, since index funds are traded on exchanges, one can buy and sell them any time and take advantage of the real-time prices.

7. Profits not restricted to capital gains - Index funds typically also hold extensive securities, which pay dividends to investors, so profits are not restricted to capital gains.

…and the underperformance…

According to data sourced from Accord Fintech, the index fund category has returned 27.34% in the last one year, 13.10% in three years, 11.2% in five years and 7.24% in the last ten years. If you compare these returns with the returns from small cap, mid cap and large cap funds, index funds lag them. In the past one year, the small cap, mid cap and large cap categories have returned 44.47%, 38.09% and 28.66%.

The latest SPIVA India suggests that the average rupee invested in equity mutual funds continues to grow faster than the index. The report points out that in the large cap fund segment 66.3%, 54.6% and 54.95% of large cap equity funds in India underperformed the S&P BSE 100 respectively over a one year, five year and ten year periods ending December 2016. But considering the asset weighted performance, large cap funds outperformed the index indicating that large cap equity funds have performed better than the index.

In the midcap space, while 71.11% of the funds lagged the S&P BSE Mid cap index over the one year period ending December 2016, a majority of the funds outperformed the index over the three, five and ten year periods.

In ELSS the underperformance was limited to 10.81% and 25% over the three and five year periods while 64.29% and 50% of the funds underperformed over the one and ten year periods. On an asset weighted basis, both categories witnessed underperformance relative to the relevant index over one year but registered outperformance over longer time frames.

…Index funds not in vogue in India

Index funds in India are not as popular in India as they ought to be. Why? Globally, it has been witnessed that 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. Today, returns from index funds are smaller compared to other diversified equity mutual funds, and investors generally avoid these funds. It has been proven that some random stocks could beat market returns.

Warren Buffett and Benjamin Graham have recommended index funds as one of the best investments for small investors who do not have the capacity to pick their own quality stocks or mutual funds. This is exactly what peddlers of index funds have been using as their rationale to sell such funds in India for long. However, it may make sense for American investors to invest in index funds simply because the index funds there are far more indicative of the broader market (as they track indices that contain 500 to 5,000 companies). In India, you have just two indices available – the 30 share BSE-Sensex and the 50 share NSE-Nifty. Such a small number of companies are not indicative of the broader Indian market. If a great company is not big or if a large percentage of its shareholding is held by promoters (which means a low free-float), it will never find itself in an index fund (while a smart fund manager would own it in his actively managed fund). Alternatively, just because it is a big company and has seen a great rise in its stock price in the ‘past’, it will sneak into the index, and thus the index fund.

Why they falter

There are several reasons index funds falter. Here are three big ones…

Index funds buy high and sell low

Index funds largely track the market capitalization of companies that form part of the index. So as a company gains in market capitalization (and thus gets expensive in terms of valuations like price-to-earnings or price-to-book value), the index fund manager has to buy more of it to get it to a higher weightage in his fund as well. On the other hand, a company that falls in market capitalization and also in terms of valuations gets a lower weightage in the index. The index fund manager follows by selling a part of this company from his fund to match its new weightage. An index fund is therefore an automatic mechanism to buy high and sell low. This tactic can never be given as a sane investment advice.

Index funds buy the past and ignore the future

Index funds tend to have the most significant portion of their assets in large, mature companies. While this may sound a ‘safe’ strategy on the face of it, the problem with this is that the largest companies in a stock market index are yesterday’s winners. They got to be the largest by delivering exceptional returns to investors over the course of many years, but in the past. However, given the way industries develop, grow, mature and then decline, it is likely that most of these companies will earn much lower returns in the future. This is however barring a major reinvention led by a strong management team, which we find in very few companies in India. So an index fund is largely a portfolio of mature companies, many past their prime and with years of stagnation or decline ahead of them. While preference needs to be given to the past performance of companies, our interest should lie in where these companies are headed in the future (not in terms of EPS numbers, but in terms of their businesses). So a company that has a great future ahead of it in terms of business potential is what should attract us. Index funds do not tend to hold such companies.

Index funds stick with stocks till they are kicked out

The ranking of the 30 largest companies in India changes nearly every second as stock prices fluctuate up and down. This is not a big deal for companies that are at the top of the rankings. However, at the bottom of the table, some companies drop out of the list while other companies manage to sneak into the top 30. As a result, the BSE periodically drops some companies from the Sensex (that are not doing well in the stock market) and adds others (that are doing well). What do you think happens before and immediately after the BSE makes these changes to the index (the Sensex)? Since index fund managers have to follow the indices’ portfolio weights in order to minimize their tracking error, they hold on to the dropped companies till the last second while active managers sell them weeks or months before they are dropped from the index (and for other reasons that are related to business performance instead of stock market performance). Index fund managers also do not start buying the newly added companies until they are officially added while active managers already have the new (and better) stocks in hand.

The bottomline, managed mutual funds still dominate the mutual fund landscape in India.