Home / Mint-lounge / Do index funds make sense?

Index funds mirror the stock indices they track. For instance, a scheme that tracks the Sensex will invest in the 30 stocks that comprise the benchmark index of the Bombay Stock Exchange. The proportion of investment in each stock will be exactly in accordance with the weight of the stock in the index.

The management of such schemes is easier. No decision is needed on what stocks must be held, for how long, and how much must be invested in each. The fund manager just needs to keep the trading to the tiny level needed to accurately track the index.

The logical fallout is on cost. Since no research is needed, there is no need for costly analysts. No brainstorming on investment strategy is required either. This translates into low management fees and such funds have low transaction costs. After all, the fund manager will not be actively churning his portfolio. It is buy-and-hold in the true sense.

So, it’s obvious that an index fund can never beat the index. Neither should it do worse. This is contrary to active management, where the fund manager will employ a variety of techniques based on research, sector picking and market timing to try and beat the market.

However, there are some problems with the way some index funds are actually being run.

Some Indian index funds’ performance in the past deviates from the very index they are supposed to be based on. While a small mismatch, called tracking error, is normal, there are funds that have underperformed or outperformed their indices by several percentage points.

Take, for instance, LICMF Index Sensex in 2003, when it returned 54.13% compared with the index’s 72.89%. In the same year, UTI Nifty Index delivered 75.03% against the 71.90% of the National Stock Exchange, the main index it tracked. For an index fund, doing better or worse than the index is definitely not a sign of good management.

There’s no doubt that index funds haven’t proved popular in India. In March 2007, just 0.2% of equity fund investments were in index funds. A year later, the figure was 0.8%.

Are investors doing the right thing by ignoring index funds? Take a look at the chart. While it’s clear that actively managed funds have outperformed indices over the longer periods, the story is somewhat different over shorter periods. Why shouldn’t the investor take the cost advantage if the returns are not higher?

In India, the expenses of index funds vary from 0.48% to 1.51% of the money managed. Market regulator Securities and Exchange Board of India has ruled that the maximum expenses charged by equity funds can be up to 2.5%, with the cap on index funds at 1.5%.

Here are some cases against index funds and some in favour of them.

Index funds tend to be popular in an efficient market. This theory holds that stock prices generally reflect all that’s known about a company. Since the theory states that all markets are efficient, it is impossible for investors to gain above normal returns because all relevant information that may affect a stock’s price is already incorporated within its price.

So, if all fund managers are investing in the same pool of stocks, it stands to reason that the average fund will do no better than the market’s average performance.

By and large, this appears to be true for the US and Europe. Studies have shown that over any given period, a majority of actively managed US funds fail to beat the market. However, this does not appear to be the case in India.

The move to a more efficient market would require a number of parameters being fulfilled, and they are time-consuming. Greater institutional participation would help the markets. Mutual funds still have a long way to go in adding depth to the market. The Invest India Incomes and Savings Survey 2007 by IIMS Dataworks shows that of the 321 million individual wage earners aged between 18 and 59, only 5.3 million invested in mutual funds. And currently, funds research just around 100 stocks, so there is ample scope to broaden their purview. The greater the participation of funds and the wider the coverage, the quicker the move towards efficiency. Until then, there will be enough opportunity for an active fund manager to tap and beat the indices.

Foreign institutional investors have stormed the market over the past few years, but they cannot be considered stable, long-term players. As for the retail investor, he is not really long term and anyway constitutes a small percentage.

A step towards greater efficiency would be more retail participation, either directly in the stock market or via mutual funds. So, until long-term institutional and retail participation increases tremendously, active fund management will stay crucial.

At some periods in time, value investing, which involves scouting for cheap and out-of-favour stocks, works. And it is here that a good and active fund manager could bring returns exceeding any index. Indexing only makes sense in particular markets and it is most persuasive among large-cap stocks.

So, does it mean if you want a portfolio of large-cap stocks you should look at an index fund? Not true. One argument always held in favour of index funds is that they own all the securities in an index, which is a fair and representative sample of the market. But this line of reasoning would hold if the index in question is a well-diversified one, which again may not be the case in India.

Look at the Sensex—it may be a barometer of the market but it is not a guideline for investing. The Sensex is certainly not diversified enough to capture all sectors. Agriculture, tourism, shipping, aviation and textiles find no place in it. The same is the case with Nifty—shipping, aviation, textiles, consumer durables, agriculture and tourism are some of the sectors that are missing.

Even if a sector is represented in the Sensex, the selection of stocks need not be the best investment. For instance, the “finance" component is limited to three banks and one financial institution. The financial institution is HDFC, but IDBI, IDFC and PFC are not present. Neither will you find Axis Bank Ltd, Kotak Mahindra Bank Ltd or Yes Bank Ltd, nor will you come across broking stocks.

Currently, most index funds track the Sensex or the Nifty, so investors are tied down to large-cap liquid stocks. Because of liquidity issues, a stock may find its way to the Sensex or Nifty, but that does not mean it is the best buy in its field. Smaller companies may provide better investment options.

But, active fund management does not guarantee higher returns either. Such funds could fall heavily when the market tanks, but if you stay on for the long term in a good fund, you can beat the market.

An argument in favour of index funds is that it is not easy identifying a good fund manager. And then there is a risk of the fund manager making some really bad calls, resulting in a dismal fund performance.

There is nothing inherently good or bad about an index fund. But the very reasons that make index funds popular in the US wouldn’t hold in India. Consider an index fund if you want a broad exposure to the market, and that too in stocks with a large market value. But even in such a scenario, it would not be wise to put all your money into such a fund.

A good way to incorporate a sensible portfolio would be to blend active and passive stock investments. You can take one index fund to form the core of your portfolio but allocate only a small portion of your overall portfolio to it. If its performance disappoints, replace it with another index fund. The balance “active" portion of your portfolio can be distributed in diversified equity funds. If you still have money to spare, you may consider a sector or thematic fund.

Meanwhile, take a good hard look at all the diversified equity funds that have been around for a fairly long time before you decide on indexing. Who knows, you may just change your mind.

Just what are index funds?

a) Index funds are mutual funds designed to replicate the performance of a specified market benchmark or index.

b) They are passively managed funds.

c) The portfolio of an index fund has the same stocks, in the same proportion, as a given index, such as Sensex

Write to us at businessoflife@livemint.com

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