What to consider before selecting an index fund

Active and passive management are two distinct ways of managing portfolios. An active fund manager’s aim is to outperform the benchmark on a risk-adjusted basis whereas a passive fund manager’s mandate is to replicate the benchmark’s portfolio and performance. With active funds underperforming, a lot of interest and assets under management are moving towards passive funds. Index funds are the most popular type of passive funds. In India, the first index fund was offered in 2001, and since then index funds have come a long way. As on 30 June 2022, there were 94 index funds in India managing around ₹83,000 crore. Currently, 19 index funds track the Nifty 50, and invest in the same 50 companies as in the index (same proportion).

A not-so-sophisticated investor might be lured to an index fund whose return is higher than the index or other index funds. The sophisticated ones care about how closely the fund is replicating the index return. The key performance statistic for evaluating index funds is tracking error (TE) which captures the deviation between the fund’s return and benchmark’s return. Sebi has provided norms for TE. The fund return can deviate from the index return for two reasons. One, due to the expenses in managing the fund portfolio as it is a real portfolio, whereas the underlying index is a paper portfolio. Low expense ratio (ER) is not a guarantee but a necessity for return replication. The table shows the ER for Nifty 50-based index funds (only select funds). All these funds hold the same securities in virtually identical percentages. Yet, they have substantially different ERs. Under direct as well as regular plan, the difference between the highest and lowest ER is 80 bps. The difference between the ERs under direct plan and regular plan is also noticeable and in some cases is as high as 81 bps.

The second reason for deviation from the underlying portfolio is the need for holding cash to manage inflows and outflows. Theoretically, an index fund has a beta of one. However, in practice, a fund’s beta exposure could differ from one, due to its cash holdings. This can be captured by calculating the beta minus 1. Funds with large AUMs (see table) seem to have an advantage here.

The way investors picked index funds provide interesting insights into investors behaviour. Rational investors should select funds that maximize their economic payoff. Since the underlying product is the same, funds with the lowest TE should attract the highest AUMs. However, the relationship between the two is weak (see table). Marketing & distribution networks may explain why some index funds in spite of high ERs and relatively higher TE enjoy larger AUMS. Clearly, the rationality of investors is overestimated. Of course, some of these low ER funds are relatively new and we are yet to see how they would attract investors. If investors were rational, index funds with higher ERs and higher TE would be weeded out of the market.

Dr Rachana Baid is professor at School of Securities Education, NISM. The views expressed here are personal.