FUND FLAVOUR

May 2017

An index fund is a collective investment scheme that aims to replicate the movements of an index of a specific financial market. Index funds today are a source of investment for investors looking at a long term, less risky form of investment. The success of index funds depends on their low volatility and therefore the choice of the index. An index is a group of securities that represents a particular segment of the market (stock market, bond market, etc.). Among the most well-known companies that develop market indexes internationally are Standard & Poor's and Dow Jones. Index funds will hold almost all of the securities in the same proportion as its respective index. Index funds can be structured as a mutual fund, an exchange-traded fund, or a unit investment trust. Since the index fund directly tracks the index composition, it does not involve active fund management. The lack of active management generally gives the advantage of lower fees (which otherwise reduce the investor's return). The difference between the index performance and the fund performance is called the "tracking error", or, colloquially, "jitter". This is usually because of the administration fees or time delays in tracking.

Index funds provide low-cost access for investors to buy and hold leading stocks. And holding them is a key strategy. In the words of Bogle, the pioneer of index funds “Time is your friend; impulse is your enemy”.

Weighing the balance…

1. Cost of Investments - The cost associated with the management of an index fund is much lesser than that of a managed fund, which requires active trading (churn). Hence, index funds save on expenses like brokerage and transaction costs. Moreover, since a fund manager is not involved, the fund management charges are lower and hence the expense ratio is lower. The average expense ratio of actively managed fund is 2-2.5%, while it is 1-1.5% in the case of index funds.
2. Management Style - An experienced fund manager, following a structured investment approach is like a visionary leader marshalling his resources. Based on the real-time developments and trend analysis, he or she can take strategic decisions that can lead the fund towards outperformance. This aspect is missing for a passive fund.
3. Limited downside - Unlike index funds that mirror the market, managed funds invest in handpicked securities. A fund manager has the freedom to limit the downside by holding only performing securities. In the case of index funds, they fall as the market falls. They are vulnerable to market volatility and systemic risk. For example, during a severe economic recession, an index fund’s value may drop considerably.
4. Fund Manager Risk - There is a chance your fund manager might make a poor decision. He might be subject to some form of systemic pressures or might end-up investing in an underperforming stock. There is a chance of him quitting the fund too. These situations can affect your investments. Index funds negate this risk by passively investing only in securities that represent a particular index.
5. Less risky - Index funds are less risky than actively managed mutual funds, since they are constructed to mirror the market, rather than outperform it. In addition, since market indexes are highly diversified in nature, investing in index funds is far less risky than purchasing one type of security or shares in a few firms.

6. Traded on exchanges - Most mutual funds can be traded only on NAV (i.e. the net asset value declared at the end of the day). However, since index funds are traded on exchanges, one can buy and sell them any time and take advantage of the real-time prices.

7. Profits not restricted to capital gains - Index funds typically also hold extensive securities, which pay dividends to investors, so profits are not restricted to capital gains.

…and the underperformance…

According to data sourced from Accord Fintech, the index fund category has returned 27.34% in the last one year, 13.10% in three years, 11.2% in five years and 7.24% in the last ten years. If you compare these returns with the returns from small cap, mid cap and large cap funds, index funds lag them. In the past one year, the small cap, mid cap and large cap categories have returned 44.47%, 38.09% and 28.66%.

The latest SPIVA India suggests that the average rupee invested in equity mutual funds continues to grow faster than the index. The report points out that in the large cap fund segment 66.3%, 54.6% and 54.95% of large cap equity funds in India underperformed the S&P BSE 100 respectively over a one year, five year and ten year periods ending December 2016. But considering the asset weighted performance, large cap funds outperformed the index indicating that large cap equity funds have performed better than the index.

In the midcap space, while 71.11% of the funds lagged the S&P BSE Mid cap index over the one year period ending December 2016, a majority of the funds outperformed the index over the three, five and ten year periods.

In ELSS the underperformance was limited to 10.81% and 25% over the three and five year periods while 64.29% and 50% of the funds underperformed over the one and ten year periods. On an asset weighted basis, both categories witnessed underperformance relative to the relevant index over one year but registered outperformance over longer time frames.

…Index funds not in vogue in India

Index funds in India are not as popular in India as they ought to be. Why? Globally, it has been witnessed that as markets become more efficient, it becomes harder for fund managers to beat their benchmarks. Passive funds progressively become the preferred investment vehicle in such markets. In the Indian market's most efficient segment, the large-cap space (funds with more than 80% allocation to large-cap stocks), passive funds have a significant presence. Today, returns from index funds are smaller compared to other diversified equity mutual funds, and investors generally avoid these funds. It has been proven that some random stocks could beat market returns.

Warren Buffett and Benjamin Graham have recommended index funds as one of the best investments for small investors who do not have the capacity to pick their own quality stocks or mutual funds. This is exactly what peddlers of index funds have been using as their rationale to sell such funds in India for long. However, it may make sense for American investors to invest in index funds simply because the index funds there are far more indicative of the broader market (as they track indices that contain 500 to 5,000 companies). In India, you have just two indices available – the 30 share BSE-Sensex and the 50 share NSE-Nifty. Such a small number of companies are not indicative of the broader Indian market. If a great company is not big or if a large percentage of its shareholding is held by promoters (which means a low free-float), it will never find itself in an index fund (while a smart fund manager would own it in his actively managed fund). Alternatively, just because it is a big company and has seen a great rise in its stock price in the ‘past’, it will sneak into the index, and thus the index fund.

Why they falter

There are several reasons index funds falter. Here are three big ones…

Index funds buy high and sell low

Index funds largely track the market capitalization of companies that form part of the index. So as a company gains in market capitalization (and thus gets expensive in terms of valuations like price-to-earnings or price-to-book value), the index fund manager has to buy more of it to get it to a higher weightage in his fund as well. On the other hand, a company that falls in market capitalization and also in terms of valuations gets a lower weightage in the index. The index fund manager follows by selling a part of this company from his fund to match its new weightage. An index fund is therefore an automatic mechanism to buy high and sell low. This tactic can never be given as a sane investment advice.

Index funds buy the past and ignore the future

Index funds tend to have the most significant portion of their assets in large, mature companies. While this may sound a ‘safe’ strategy on the face of it, the problem with this is that the largest companies in a stock market index are yesterday’s winners. They got to be the largest by delivering exceptional returns to investors over the course of many years, but in the past. However, given the way industries develop, grow, mature and then decline, it is likely that most of these companies will earn much lower returns in the future. This is however barring a major reinvention led by a strong management team, which we find in very few companies in India. So an index fund is largely a portfolio of mature companies, many past their prime and with years of stagnation or decline ahead of them. While preference needs to be given to the past performance of companies, our interest should lie in where these companies are headed in the future (not in terms of EPS numbers, but in terms of their businesses). So a company that has a great future ahead of it in terms of business potential is what should attract us. Index funds do not tend to hold such companies.

Index funds stick with stocks till they are kicked out

The ranking of the 30 largest companies in India changes nearly every second as stock prices fluctuate up and down. This is not a big deal for companies that are at the top of the rankings. However, at the bottom of the table, some companies drop out of the list while other companies manage to sneak into the top 30. As a result, the BSE periodically drops some companies from the Sensex (that are not doing well in the stock market) and adds others (that are doing well). What do you think happens before and immediately after the BSE makes these changes to the index (the Sensex)? Since index fund managers have to follow the indices’ portfolio weights in order to minimize their tracking error, they hold on to the dropped companies till the last second while active managers sell them weeks or months before they are dropped from the index (and for other reasons that are related to business performance instead of stock market performance). Index fund managers also do not start buying the newly added companies until they are officially added while active managers already have the new (and better) stocks in hand.

The bottomline, managed mutual funds still dominate the mutual fund landscape in India.