FUND FLAVOUR

May 2020

Investing in the index…

Did you know that between 1979 and 2019, the Sensex moved from 100 to 42,000? In other words, your investment has compounded annually at 16.3% for 40 years. This is just the capital appreciation part. If you add the average dividend yield of 1.5%, the Sensex has compounded at 17.8% annually for the last 40 years. But, how do you invest in the Sensex? That is where an index fund comes in handy.

…in a nutshell

·         Index funds can be taken as a long-term, less risky form of investment

·         The success of these funds predominantly depends on the choice of index and their low volatility·         Given the dependence of these funds on the performance of an index, index funds are passively managed; hence, these funds are not meant to outperform the market but instead mimic the index’s performance·         Since these funds create a portfolio that almost replicates the chosen index, the returns offered by these funds are also similar to that of the index·         Due to the passive management of these funds, they involve lesser expense ratio and thus, low expenses·         Index funds are, additionally, known to provide broad market exposure and low portfolio turnover to the investors

The modus operandi of Index funds and…

An index fund is a mutual fund that mirrors the portfolio of the index. Unlike an active fund, there is no stock selection. When you buy an index fund, just look at which index the fund is benchmarked to. The portfolio of the fund will mirror the stocks in the index in approximately the same proportion. As per the guidelines, the minimum investment in securities of a particular index that is being replicated or tracked must be 95% of the total assets. In India, many of the schemes use Nifty or Sensex as the base to construct their portfolio. For example, if the Nifty portfolio constitutes of SBI shares whose proportion is 12% then; the Nifty Index fund will also have 12% equity shares. The weightage of a company in the Sensex or Nifty depends on its free float market capitalization. It is a percentage of the total market capitalization of the index. So, if the market capitalization of a company is Rs 1 crore, while that of the index is Rs 200 crore, its stock has a weightage of 0.5%. The work of an active fund is to meet the benchmark allotted to it. But the purpose of an Index fund is to be as efficient as its index performance. These typically yield returns that are almost equivalent to the benchmark. The index could slightly differ from the results of the fund. This is known as tracking error. The work of a fund manager is to make sure that the tracking error is the lowest possible figure. Index funds offer you a smart and efficient method of participating in the stock market without taking on too much of stock specific risk.

… how different it is from…

…mutual funds…

 

1.      Investments: Index funds, as well as the mutual funds, consist of stocks, bonds and other types of securities. However, index funds focus on tracking stock consisting of different indexes like Nifty, Nasdaq, etc.

2.      Management: One major difference is the management. Index funds are passive, that is, they do not actively trade or add investments while mutual funds are active, which means that the fund managers actively pick up fund holdings after analyzing them.

3.      Objectives: The main objective of the index fund is to generate the same returns as the benchmark index. While mutual funds aim to beat the returns of the benchmark index. If the market is volatile, then it would be harder to pull out your index funds at short notice.

4.      Cost: Mutual funds will cost you more in terms of expense ratio (fees around 1%-3%). Index funds, on the other hand, have lower costs with annual fees in the range of 0.05% to 0.07%.

…and ETFs

An Exchange Traded Fund or an ETF tracks an index, like an index fund. But the ETF units are listed as well as traded on the stock market and cannot be bought easily from an Asset Management Company (AMC) or even sold to a fund house. You need a Demat and a trading account to buy a unit of ETF and you need to buy them in the stock exchange.

The index fund, on the other hand, could be opted for by any other mutual fund directly or even redeemed. Index funds, sometimes, only hold units of an ETF of the same AMC and in other times, Index funds directly hold the stocks included in the index. There are some indices that are not traced by Index Funds but are tracked by ETFs. Indexes like Nifty Value 20, Nifty Low Vol 30 are tracked by ETFs which are not tracked by Index funds.

 

Why and…

1.      Diversification: An index is a collection of different stocks and securities. They offer diversification to the investor which is the main motive of Asset Allocation. This ensures that the investor does not have all his eggs in one basket.

2.      No Fund Manager’s risk: The allocation of assets, in this case, is not according to the will of the fund manager. So, there is no visible scope of making losses due to improper asset allocation or perhaps, poor management.

3.      Low Expense: Index funds are managed passively, so the total expense ratio, i.e. the TER is very low when compared to those that are actively managed. An actively managed fund could charge you anything around 1-2% as TER. On the other hand, an Index fund would just charge you in the range of 0.2% to 0.5%. The cost difference could seem very small at the face value but in the long run, it could turn out to be a huge sum of money.

4.      Stock-specific Risk: Given you invest in a basket of securities you tend to bet on the broader market or asset class. The single-stock exposure in case of the index is limited, thereby causing limited damage.

5.      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.

…why not

1.      Difficult to generate alpha: It is tough for a fund manager to outperform the stock market every time but many investors and actively managed funds are actually able to outperform the market. The Index funds do not have that potential since they have the tendency to track the market performance not of exceeding it.

2.      Restricted protection: Suppose you have invested in an Index fund which tracks Nifty50, it will soar when the market is doing well but will leave you vulnerable when the market is not doing so well. During a market correction, it would be difficult to turn your costs into an average value since the weightages of the underlying index have to be looked after.

3.      Cannot avail sudden opportunities: Often, an obvious mispricing occurs in the market. This could be a good opportunity to add up on good quality yet beaten down socks in the sector. However, an Index fund would be unable to make use of this opportunity to the fullest and will fetch you suboptimal returns.

4.      Only mature companies: The index companies are mostly the mature companies who have their best growing years in the past. Investors in index funds cannot benefit from the high growth potential of the emerging small companies.

5.      Not flexible: Index funds are passively managed. And because they have to follow certain strategies to remain that way, they turn out to become less flexible in nature. Managers of an actively performing fund have more options to search for stocks in order to fit the goal.

6.      Market risk: Index funds have a direct relation with the market. So, when the stock markets fall as a whole, so does the value of the index mutual fund.

Who should invest and …

Index funds are ideally suited for investors who

·         like to stay put with their investments for the long term

·         are willing to stay away from constant monitoring and juggling of their mutual fund portfolio

• are looking to gain from the mirror returns of SENSEX, NIFTY, etc.

• are looking for a buy-and-hold over long term of 5 years or more

·         wish to get better returns than Fixed Deposits over long term

·         who are risk-averse since these are known to be less prone to equity-related volatility and risks

…what criteria

There is a risk in taking a futuristic view based on past data but here are five basic rules you can follow to zero in on the best index fund.

·         Look for consistency of returns. If you are wondering why we are looking at 1-year returns for index funds (these are long term products), the idea is to check for consistency. The returns across various time frames should be consistent with the group. That makes the index fund more predictable.

·         Index funds do not have to spend on fund managers to find multi-baggers. Indexing is a passive approach and hence the lower cost gets passed on to you in the form of lower total expense ratio (TER). That helps to enhance returns. You can even opt for Direct Plans to reduce costs further.

·         One unique parameter you must consider in index funds is the tracking error. It measures the extent to which the index fund deviates from the index. Normally, an index fund should have low tracking error.

·         Given a choice, prefer the index fund with the larger AUM as small AUMs can come in the way of effectively replicating the index.

·         Take a long term view when you invest in an index fund. Markets tend to be cyclical and hence you must keep an investment horizon of at least 8-10 years for an index fund.

Index funds save you cost and the risk of stock selection. A bit of homework on your part can leave you with a satisfying and profitable journey investing in index funds.

The myths and …

While the word 'index' may conjure up an image of safety and reliability that is not always the case. That is partly because the funds track everything from widely known indexes like the Standard & Poor's 500 index to one custom built for the fund and without much of a track record.

Index funds should move in lockstep with the benchmark index they are tracking. But before you jump on the broad exposure to the stock market that index funds offer, it helps to understand what they are – and what they are not.

Index funds are safe. Index funds generally tend to be less volatile than most individual stocks. But they are only as stable as the underlying index.

Index funds match exactly the funds they track. Fund managers make adjustments to index fund holdings that may not be an exact replica of a sector. But even if they were, index funds would under perform because of the fees associated with the fund.

Index funds are passive. There may be more to an index fund than just following the market. Benchmark [index fund] selection is an 'active' decision. Investors should try to understand the construction and methodology of the fund's benchmark to see if it matches their goals and objectives.

Index funds perform consistently. An index fund can under perform its benchmark for many reasons, including a high expense ratio, which may include hidden fees that can make an index fund expensive. Also look at turnover, which is how often assets in the fund change - the higher the turnover, the more costly the fund. This is especially relevant in a mutual fund index. An index ETF will provide more tax advantages than index mutual funds because mutual fund managers often distribute taxable gains at the end of the year.

Index funds are good for the short term. Some index funds could experience less volatility than others, and some are designed for shorter holding periods. But do not invest in an index fund unless you can sit it out for at least five years.

 

…the investors’ trust

 

The total assets managed by the passive funds in India, including gold and other ETFs and index funds, stood at Rs 177,181.22 crore as of November 30, 2019. Mutual fund schemes that follow passive investment strategy such as index and ETF schemes earned the trust of advisors and investors in 2019. The out performance of passive large cap mutual funds in 2019 and lower alpha generated by the actively-managed funds contributed greatly to the increase in popularity of the category. The index fund category came into its own after the re-categorisation of mutual funds by SEBI. So, AMFI data is not available for previous years. Large Cap ETFs managed to offer YTD returns of 11.53%, compared to 10.19% offered by actively managed large cap funds. The AUM rise is solely because of the performance. Passive funds are low cost, so they have an extra edge there. For most part of the year, passive large cap schemes were at the top of the return charts. However, some active schemes have taken the top slots in the later part of the year. Even now, 9 out of the top-performing 15 large cap schemes are passive funds. This year also saw the launch of mid and small cap index funds. Motilal Oswal Mutual Fund launched the Motilal Oswal Nifty Midcap 150 Index Fund and Motilal Oswal Nifty Smallcap 250 Index Fund this year. If active managers do not deliver value for the fees they charge, in any case media, intermediaries and investors themselves in this age of information explosion will eventually make their choices. Though assets of passive funds in India surged in 2019, awareness is still low, impeding progress. There was a time when passive investing was summarily dismissed by Indian investors. With the Indian equity market in a strong uptrend until 2017, most fund managers managed to beat the benchmarks effortlessly, presenting a strong case for active fund management. But the tide seems to be gradually turning. There was a strong inflow into equity exchange traded funds (ETFs) in 2019. Of the 31 large-cap funds, 16 have failed to beat their benchmark returns in 2019. Of the 43 ELSS funds, 28 delivered returns that are lower than their benchmarks. Under performance in many sectoral funds was also stark. That said it is also obvious that Indian fund managers are able to generate alpha, when given sufficient room to perform. Under-performance among mid-cap funds was just 4 per cent, while only 19 per cent of the small-cap funds did worse than their benchmarks last year. Passive investing would work better in the large-cap segment while managers can outperform the benchmark in small- and mid-cap segments. Under performance in the large-cap funds is due to various reasons including excessive demand for larger stocks that are perceived as less risky, making their valuations pricey, limiting options in this segment. The biggest factor favouring index funds and ETFs is the lower expense ratios that help increase returns, due to the compounding benefit. This tends to play a larger role in periods when equity returns are muted. While the compounded average annual growth in the Sensex was 21 per cent between 1980 and 1999, in the next two decades, the growth slowed down to around 12 per cent. The annual growth since 2010 has been even slower, at 7.5 per cent. But while there is a strong case for turning towards passive funds, the movement is yet to gain traction in India. ETFs and index funds account for just 6.5 per cent of total mutual fund assets in India. One factor that is impeding the growth of passive investing in India is the lack of interest from mutual fund distributors, due to the lower commission on these funds. With 85 per cent of retail investors in equity mutual funds relying on advisers to invest, SEBI could consider allowing mutual funds to pay slightly higher commissions for pushing index funds and equity ETFs to retail investors. This can help increase awareness about these products. Index funds are preferred over ETFs by mutual fund investors since index funds can be purchased even if the investor does not own a demat account. Also, it is possible to undertake SIPs (systematic investment plans) in these. But despite the obvious benefits, corpus of index funds in November 2019 was only Rs 7,717 crore. While this is up from Rs 4,385 crore in November 2018, it is still woefully inadequate.

Index funds to gain in future, but active funds are here to stay

Passive funds are unlikely to dethrone active funds immediately in India. However, the recent regulatory changes and ensuing market volatility have shifted focus firmly to passive funds in the country. In India, index funds are yet to gain momentum. One of the primary reasons for this is the fact that active mutual funds, on an average, have been delivering returns which are better than respective benchmarks. If one were to look at the top 25 equity mutual funds by size, on an aggregate, these funds have delivered 2% per annum return ahead of the Nifty over the past decade. This is after the management fees of these funds. This can partly be explained by the fact that mutual funds in India are relatively small, compared with the overall market and one can expect “professional fund managers" to do better than retail investors. But 2018 seems to have been a landmark year where active funds failed to beat Nifty. Only time will tell if this is a one-off occurrence. Over the next decade, index funds will gain prominence, but given the track record, active funds are likely to deliver returns better than the index for some time to come.