FUND FLAVOUR

May 2019

Passive strategy…

Index funds, as the name suggests, invest in an index. These funds seek to invest in all the underlying securities in the same proportion as that of the index. The objective of an index fund is to replicate the performance of the index. These types of funds are passive funds. They do not require active management. The success of the index fund is determined by how close it is able to replicate the performance of the underlying index it is copying. This is measured by tracking error. An investor should invest in index funds should they have any reservations with respect to the ability of a fund manager in generating alpha over the benchmark returns. Further, if an investor is looking to play a low-cost strategy, index funds are best suited. Furthermore, index funds are also helpful to remain fully invested in equity at all times. For investing in an index fund, an investor has three options generally:

§  A fund that tracks the Sensex – 30 stocks

§  A fund that tracks the Nifty – 50 stocks

§  Index plus fund – Fund invests a portion in an index and the remainder is actively managed

…pays…

There are multiple benefits for investing in Index Funds. Few of them are given below.

Less Influenced by Fund Manager

The influence of the fund manager in these types of funds is very less. It removes the real risk of fund manager error. Funds are passively managed and tracking to specific index is only required by the fund manager.

Lower Expenses

The expense associated with these types of funds is very low. Typically, the range for these funds is around 0.2-0.5%, which is much lower than the 1.3-2.5% often seen for actively managed funds. The main reason is these types of funds eliminate the requirement of a dedicated team of research analysts to carry out stock analysis. The fund has to simply replicate the index, so expense ratio of these funds is very low. The lower expenses lead to a better return.

Diversification and Risk

As the index is made up of multiple funds, these funds are well diversified in nature. Asset allocation is managed automatically. It indirectly reduces the risk associated with these funds.

Tax-efficient

Index funds pay fewer dividends than actively managed mutual funds and they also have a low turnover rate. (Low turnover refers to the amount of funds that have been replaced, or turned over, during a given year, which results in capital gains taxes.) Low turnover equals low taxes, so index funds are a great place to park your money if you are interested in lowering your tax bite.

Suitable for the Efficient Market

As markets become efficient, it gets difficult for fund managers to beat their benchmarks. In this scenario, passive funds become the preferred investment vehicle.

A "set it and forget it" format allows you to invest in the index fund .You do not have to track individual stocks or indices every day.

It is true that over the short term, some mutual funds will outperform the market by significant margins. Picking those high performers from the literally thousands out there is almost as difficult as picking stocks yourself! Whether or not you believe in efficient markets, the costs that come with investing in most mutual funds make it very difficult to outperform an index fund over the long term.

…or does it not?

An investor buying into an index fund gives up the chance of beating the market by picking a good actively managed fund.

No Alpha or Outperformance

Active fund managers seek to outperform the benchmark index. Thus, if you have invested in passive funds, do not expect any outperformance as these funds are not actively managed and are only a replica of the index.

Mature companies only

Index companies tend to be mature companies who have their best growth years behind them. Investors in such funds do not benefit from the growth potential of small companies.

Expensive Valuations

Companies in the index have been discovered by the market. In other words, investors are buying stocks which are already expensive.

Before you leap, look into a few things…

Identify the Index for your portfolio

The first step is identification of index (Sensex, Nifty) suitable as per your risk appetite. You should see the stocks where investment is made by the index.

Tracking Error

You should also look at the tracking error. Lower the tracking error better is the index fund. It is a parameter that reflects an ability of a fund to replicate the performance of the benchmark index.

Performance of Fund

Performance of fund is another important parameter. You should compare the performance of the fund with a benchmark index to get an actual idea. Apart from that peer comparison is also important.

Expense Ratio

Expense ratio is another important factor for the selection. The expense ratio of the index fund should be low. You should avoid the fund which unnecessarily charges higher administration and other expenses. On the other hand, do not select funds only on the basis of expense ratio.

Index investing in India

Most index funds in India track the benchmark indices – Nifty and Sensex. The Nifty Next 50 is another popular index. It is an index of the 50 largest stocks that follow the Nifty 50 stocks. The Nifty Value 20 (NV) Index is another popular index for trackers (through ETFs). The Nifty Value 20 tracks relatively undervalued stocks as measured by parameters like PE or Price to Earnings ratio, PB or Price to Book ratio, Dividend Yield and Return on Capital Employed (ROCE). The NV 20 has 5 year returns of 11.97% and 1 year returns of 8.55%. It is tracked by ETFs like ICICI Prudential NV 20 ETF and Kotak NV 20 ETF. Other indices like the Nifty Low Vol 30 ETF are also being tracked by ETFs like ICICI Nifty Low Vol 30 ETF. The Nifty Low Vol 30 tracks stocks with relatively low volatility. It has 5 year returns of 15.92% and 1 year returns of -0.52%. The largest Index Fund in India with respect to size is the UTI Nifty Index Fund with a corpus of Rs. 936 crore. However, it is the ICICI Prudential Nifty Next 50 Index Fund that has yielded the highest 3-year and 5-year returns of 13.44% and 21.87% respectively. HDFC Index Fund Nifty 50 tops the returns chart with a one-year return of 18.17% closely followed by UTI Nifty Index Fund at 17.98%.

Warren Buffett made a very interesting observation that 60 years ago or so if he had put in money in index funds vis-à-vis gold, the kind of returns he would have made would have been incomparable or phenomenal. Talking about index funds back home, they have a low expense ratio versus other funds. But it does not have a very compelling case for investment in India simply because

a) When Buffett is talking of index or the largest index fund in the world, he is talking of S&P 500. In India, we do not have a broad-based index. Our markets are very narrow and very shallow. 

b) When we talk of S&P 500, they are made up of globally competitive businesses built in a very competitive environment of free market, whereas in India, our markets are not free. All the segments of the economy are not publicly listed and traded.  

c) At a certain level, indexing becomes a self-fulfilling virtuous cycle in a way that if you have a lot of pension funds and if you have a lot of money getting into index funds then index funds themselves become drivers. In that sense, large proportion of money flowing into index fund itself sustains the index and we are beginning to see some of those variables falling in place in India in the last three and a half years. 

We saw the emergence of India’s largest equity fund -- Nifty ETF. This has become a Rs 45,000-crore fund and that can be attributed to Employee Provident Fund making its investments there. We have mandatory savings flowing into equity, because institutional money generally finds index funds attractive as they do not have anybody to blame for underperformance or outperformance and are able to account for it more efficiently. So that way NPF money, EPF money flowing into index funds itself is a driver but the reason why index funds have not taken off in India in the last 20 years is because actively managed funds have delivered superior returns despite high expenses. Expenses might come down and index funds might have a stronger case in the future but the jury is still out. We do not have the index vehicles to invest in the multicap and the smallcap segments, where magic happens in India.