FUND FLAVOUR

June 2021

Passive investing …

An Index fund tracks a broader market index such as Sensex or Nifty and its portfolio will comprise the same stocks as in the Sensex or Nifty in the same proportions. The Securities and Exchange Board of India, SEBI defines index mutual fund as, ‘open ended mutual fund scheme which replicates 95% of assets of its benchmark’. Index funds are also known as passive funds since they track a particular index and do not require a high level of management of the fund. The fund manager, who is managing the fund investments looks after the stocks which have to be bought or sold according to the composition of the underlying benchmark. In India, NSE’s NIFTY 50 and BSE Sensex are popular benchmarks for index mutual funds. A NIFTY index fund will have the same 50 stocks, in the same weightage as in NIFTY 50 Index. A Sensex index fund will invest in 30 stocks, in the same proportion as in Sensex. As far as the return is concerned, the fund and the index deliver almost the same return. The difference between the two leads to the origination of tracking error which the fund manager tries to minimize.

 

…of various hues

The wide array of index funds available in the market are enumerated below:

1.      Broad Market: A big market would naturally want to capture a wide range of the market. Large market index funds usually have the smallest expenditure ratios. The asset sales in broad index funds are generally small and tax-efficient as well. This is suited for those investors who wish to achieve a huge variety of shares or bonds.

2.      International Index Funds: The Global Index funds offer international exposure. An investor could opt for funds that monitor indices that are no longer linked to any particular geographic region in the emerging or frontier markets.

3.      Market Capitalization: The investors who are involved in the long term investment horizon would benefit from an increased exposure towards a wide range of small and medium enterprises by investing in index funds via market capitalization.

4.      Bond Based Index Funds: Bond Based Index funds could help in maintaining a balanced combination of short, intermediate and long term bond maturities which result in steady revenues.

5.      Earnings Based: Index funds also have the capability of working on the basis of the profits or revenues gained by a company. The growth indices are generated with businesses with the expectation of generating profits faster than others in the market. The value indices consist of stocks that are trading at a lesser cost as compared to the company’s earnings.

ETFs vs Index Funds

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. A Demat and a trading account are needed to buy a unit of ETF in the stock exchange. The index fund, on the other hand, could be purchased or even redeemed just like any other mutual fund. There are some indices that are not traced by Index Funds but are tracked by ETFs. Indices like Nifty Value 20, Nifty Low Vol 30 are tracked by ETFs which are not tracked by Index funds.

Rationale for index funds…

You may be intrigued given that index funds just track a benchmark and not seek to outperform. Outperformance is always better than just benchmark returns. Markets are a zero-sum game, meaning for every person making money, somebody has to lose money. This means that all active managers collectively cannot beat the market. The reason is cost, and they are the biggest drag on the performance. An active mutual fund seeks to outperform any index, which means it needs the resources to do so. This involves hiring a group of expert analysts, getting the best Chief Investment Officer(s), the best research, the best tools and other things. All this does not come cheap, and there are costs involved. On comparing the expense ratios of active large-cap mutual funds and index mutual funds, the category average expense ratio of active mutual large-cap mutual funds (direct plans) is 1.28% whereas it merely ranges from 0.2 to 0.5% in the case of index funds.

Index Funds – one up on active funds…

1.      Lower costs : Since index funds are passively managed, the total expense ratio (TER) is very less as compared to the actively managed ones. While an actively managed fund may charge anything between 1-2% as TER, an index fund would typically charge between 0.20% to 0.50%. At face value, the cost difference may seem small but in the long run, the difference can be as large as 15% of your net returns.

2.      Mitigation of risk: By investing in index funds, the investors take exposure in the index which helps them in mitigating the unsystematic risk for the investors. Unsystematic risk means a risk which is associated with a particular stock or industry.

3.      Diversification: Index funds allow diversified exposure as all the leading companies form part of the index. Auto diversification allows investors to reduce the risk of staying invested in a particular stock or sector like auto, pharma etc.

4.      Management: The fund manager of an actively managed fund is constantly under pressure to beat the benchmark. So, he invests in various companies to increase profit. This is a double-edged sword. One wrong investment decision can lead to huge losses. This does not happen in an index mutual fund. In an index fund, the fund manager has no scope to change the allocations. Hence an index mutual fund eliminates management errors.  

5.      Taxation on Index Funds: A capital gain arises on the redemption of units of the index fund. The gains can either be short-term or long-term depending on the holding period of the units. If the units are sold within a period of 1 year from the date of the allotment, this would give rise to short-term capital gain and is taxed @ 15%. Furthermore, the long-term capital gains are taxed @10%, above Rs, 1,00,000 without the benefit of indexation. For example, if there is a long-term capital gain of Rs. 2 lacs and the investor withdraws this amount after a year of investment, the tax will be levied on Rs. 1 lac and the amount payable will be Rs. 10,000.

6.      Efficient Market Hypothesis: An Index fund which is a representative of the market shall outperform all active funds in the long run. According to the efficient market hypothesis, markets cannot be outperformed by any fund manager or investor. Competitors get to know about the price anomalies at a certain point of time and the stocks are kept at a price according to their fundamental value.

 

On the flip side…

1.      Outperformance ruled out: 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 outperform since they have the tendency to track the market performance not of exceeding it.

2.      No control on stock selection: while an active fund manager can refrain from investing in poor quality stocks, an index fund manager might have to invest in such stocks if they form part of the underlying index. Hence, protection will be restricted to a great extent. Moreover, the index fund manager cannot avail of certain unexpected opportunities to add up on good quality yet beaten down socks in the sector. Therefore, they have to settle down for suboptimal returns.

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

 Criteria to contemplate…

1.       Investment Horizon: Index funds are suitable for investors who have a long-term investment horizon. The fund return might fluctuate in the short-term but it usually evens out in the long run. It is important to stick to the fund over the decided horizon so as to reap the full benefit from the fund.

2.       Financial Goals: If the investors make sure to stick to the investment horizon, index funds are able to offer better returns, which in turn will help the investors to achieve their financial goals. This can include retirement, wealth creation etc.

3.       Risk Tolerance: Index funds are not prone to or less prone to the volatility related to equity and risks because they map an index. Index funds lose their value when there is a market downturn. It is advised to invest in a mix of actively managed index funds.

4.       Taxation and Expense ratio: Index funds usually have better taxation and a lower expense ratio when compared to other funds. If there are two funds tracking, say Nifty, both will generate a similar return. The fund which will have a lower expense ratio will provide a higher return on investment.

5.       Return Factor: Index funds passively track the performance of the underlying benchmark. They do not proceed with the goal of beating the benchmark. These funds just have the motive to replicate the performance of the index. The returns generated might not meet the index return due to tracking errors. An investor should shortlist funds which have minimum tracking error before making an investment in an index fund.

 

Index Funds vs. Active Funds

Over the last 1-3-5 years, the average return of the index fund category has been over 60 per cent, 12.5 per cent, and 13.25 per cent respectively. Nifty 50 return over the same period has been 70 per cent, 13.5 per cent and 13.65 per cent respectively. In contrast, active funds (large-cap) have delivered returns between 10 per cent to 17 per cent over the last 3 years and also over the 5-year period. While active funds have the potential to beat market returns, there is always a possibility of some active fund underperforming the market over a certain period of time. According to a recent report from S&P Indices Versus Active Funds (SPIVA) India Scorecard, over the one-year period ending in December 2020, the S&P BSE 100 was up 16.84%, with 80.65% of funds underperforming the benchmark. Over the second half of 2020, 100% of the funds underperformed the S&P BSE 100. Over longer horizons, the majority of actively managed large-cap equity funds in India underperformed the large-cap benchmark, with 68.42% of large-cap funds underperforming over the 10-year period ending in December 2020.

 

A study by mutual fund research firm Morningstar showed that several key categories of mutual funds on an average failed to beat their benchmarks in the year of lockdown. The study looked at performance from 25th March 2020 to 22nd March 2021. 25th March 2020 was the start of India’s nationwide lockdown. In another variant, it looked at returns from 19th Feb 2020 which was the start of the 2020 COVID correction to 22nd March 2021. In the second variant as well, mutual funds across several categories failed to beat their benchmarks. Only 3.45% of large cap funds beat the benchmark in the lockdown year (25th March 2020 to 22nd March 2021) according to the report. The proportion was higher for mid-caps (24%) and small caps (8.70%). In case of multi-caps, just 11.76% of funds beat their benchmarks. The numbers are slightly better if the period from 19th February is considered, with 6.90% of large cap funds, 32% of mid cap funds and 18.18% of mutual funds beating their benchmarks.

 

The failure to beat came despite strong performances by various mutual fund categories in the lockdown year. According to the report, large cap funds on an average delivered 77.76%, mid cap funds gave 96.53% and small cap funds delivered 117.59%. However, all these returns fell well short of indices. For instance, large cap funds on an average underperformed by 14.11%, mid-caps by 10.89% and small caps by 16.39% implying that investors lost out on a large chunk of returns. The S&P BSE 100 delivered 91.87%, the S&P BSE Midcap gave 107.42% and S&P BSE Small Cap gave 133.98% over the same period, according to the report (for Total Returns Indices or TRI). While active fund managers have found it difficult to beat the benchmark over a one-year period, their performance over the medium term (three years and five years) has shown better success rates relative to the benchmark. The polarization of markets witnessed in 2018 and 2019 have now diminished and the sharp bounce back witnessed since March 2020 has been broad based. There are a number of reasons. First, some stocks like Reliance Industries led the rally last summer but mutual funds were barred by regulations from having more than 10% of their assets in a single stock. Second, actively managed funds have underperformed in bull markets historically. Third, the market concentration of the earlier years gave away in the latter part of 2020 to a wider set of stocks rallying. Active managers who run a growth style did relatively underperform.

 

Based on the numbers at any given point, the chances of picking a consistently performing active fund is worse than 50:50. In the case of large-caps, it is consistently worse. And it is going to get worse as the Indian capital markets deepen. Let us take the case of large-caps, and there are 40 AMCs and 40 large-cap funds. Broadly speaking everybody has access to the same information and everybody can only invest in the top 100 stocks, outperforming the benchmark is not easy, not to mention the cost disadvantage they have vs index funds. And there is also the issue of funds just hugging benchmarks which is quite common – this is also referred to as closet indexing. Most funds do not deviate significantly from the benchmarks, and after expenses, they are guaranteed to underperform the index.

 

The final musings…

Index funds are passive mutual funds and aim to achieve wealth creation for investors by replicating the performance of an index. Index funds may be less risky as compared to active funds due to this reason. Such funds help balance out the portfolio across the risk parameter. Even though index funds map a particular index, one should not blindly invest in one of the best index funds. Do your due diligence in research and find out if these funds suit your portfolio and how much you should invest in them.