As an investor in an index fund, most of you would be clear—you do not want fund managers to manage your money, but want your returns to mimic those from the benchmark index. Since buying all 50 scrips that are part of, say, the Nifty is not possible, you invest in an index fund that tracks Nifty. But when your index fund starts to outperform, or worse underperform, the index consistently, should you be worried?
We took a look at the performance of index funds across different time periods. We looked at their one-year returns over four different month-ends (March, June, September and December) in 2009 and 2008. Though index funds are mandated to return almost in line with their respective benchmark indices, often many of them have given returns that are way off the mark. For instance, as on December 2009-end, LIC Index-Nifty returned 65.86% against its benchmark index, Nifty (total return index), which gave 73.2%. As on June 2009-end, while Sensex (total returns index) returned 11.8%, HDFC Index Fund–Sensex returned just 3.85%. Such examples are not uncommon in the space.
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If your index fund is underperforming its benchmark index by a huge margin, it’s bad news. But if it outperforms the index, it’s not good news in the long run either. Here’s why.
Index funds are mandated to be passively managed. Unlike actively managed funds that decide which scrips to buy, sell and when, index funds merely invest in all the scrips—in the same proportion in which they lie—in the benchmark index. So, even if your index fund occasionally outperforms, it doesn’t necessarily mean it will always do so. It is not an index fund’s mandate to actively outperform the index. If you are looking for outperformance, you may want a fund manager’s intervention through actively managed funds.
Index funds, much like other mutual fund schemes, incur expenses on cost heads, such as marketing, advertising, office administration, brokerage and so on. These expenses reduce your scheme’s returns. This deviation in performance is called tracking error and is expressed in percentage terms.
The lower the tracking error, the better the fund. Most mutual funds have mentioned an upper limit of 2% as the permissible tracking error limit in their offer document.
How well an index fund manages its inflows and outflows also determines tracking error. While investors can invest in a fund till 3pm to get the same day’s net asset value (NAV), index funds only have between 3pm and 3.30pm to realign their portfolios (buy and sell existing or new scrips that may have entered or exited the index) and deploy additional inflows in the market by buying a fresh stock of scrips. If application comes in the last moment, close to, say, 3pm, but the fund comes to know about it much later, it can deploy this application in the market only the next day.
However, the investor gets the same day’s NAV as he invested before 3pm. Any sharp movement in the markets in the interim distorts the inflows and leads to a tracking error.
Fund houses are increasingly working to improve their internal communication and sensitize their branches so that information about inflows reach the fund managers in time. “We have focused on setting right procedural issues involved in reporting of inflows. We are confident that these have been set right and, hence, our tracking record is expected to reduce in future,” says Vinay R. Kulkarni, senior fund manager, HDFC Asset Management Co. Ltd.
Additionally, funds such as LIC MF have stopped accepting large-sized inflows on days that it feels it can distort the fund’s balance. “We don’t want volatile entries,” says S. Ramasamy, fund manager, LIC Mutual Fund Asset Management Co. Ltd.
At times, when the weights of the underlying scrips of an index change, index funds are mandated to buy and sell accordingly to rebalance their portfolios. Selling scrips would fetch them money after two days, but they need to pay money for scrips they have bought within a day. “Such imbalances of payment also lead to tracking error,” says Krishnan Daga, fund manager, Reliance Capital Asset Management Ltd.
High cash levels
Though most index funds can hold cash up to 10%, some exceed their cash levels at times to account for unexpected inflows or to make provision for unexpected redemption. If index funds have high cash levels, they don’t move in tandem with their benchmark index, thereby causing a higher tracking error.
Industry sources say that apart from small corpus sizes, some index funds also delay deploying their cash if they feel that the equity market will drop. Sources add that some index funds invest in derivative instruments. For instance, if the fund manager feels that markets are going to fall, they hedge their portfolios by selling index futures. Though such moves bring temporary relief, they can backfire if your fund manager fails to predict the market correctly.
What’s the alternative?
With investors yet to warm up to the idea of index funds, their tiny corpuses will always be susceptible to a sudden gush of money coming in every once in a while. It’s how your index fund manages its internal systems that will ensure timely deployment of money and lower tracking error.
Index funds from fund houses, such as Franklin Templeton, UTI, Principal, ICICI Prudential and so on, have consistently managed a low tracking error.
Alternatively, you can opt for exchange-traded funds (ETFs). These are close cousins of index funds as they, too, invest in a basket of index scrips. However, on account of their superior structure, these funds mimic their respective indices as closely as possible, incur lower expenses and also sport a much lower tracking error.
Since ETFs are only available on stock exchanges, you need a demat account to invest in them. The other drawback is that you cannot start a systematic investment plan (SIP) through them. For SIPs, you still need an index fund.
Graphic by Ahmed Raza Khan/Mint