FUND FLAVOUR

May 2018

A passively managed fund simply identifies the stocks and their proportion in the market index and then they mirror the same in the portfolio. With 50 companies listed on the National Stock Exchange, its index, Nifty is the most popular index in India. Sensex, on the other hand, has 30 companies listed on the Bombay Stock Exchange on its index. These indices have pre-defined allocations for each of the stocks. When any of the stocks change in proportion, the portfolio is adjusted to reflect the changes. Index funds do not require active research on the investment opportunities to find out which stocks to buy and at what prices or when. Index funds simply require passive management of the funds so that they are invested in the pre-set portfolio. When there is a change in the market index, the fund should replicate these changes to reduce the tracking error. The success of index funds lies in minimizing the tracking error so that it reflects the market index as closely as it can.

Why are index funds so popular in the US?

Most investors in countries like the USA and Europe find index funds to be a great success. Research on investments in the US has shown that over a given period of time, a large number of actively managed funds usually fail to beat the market. This is because they have a far more efficient market than India. You may have come across the sales pitch of Warren Buffet and Benjamin Graham recommending Index funds. What is being told is true, but it does not make complete sense unless you realize that they are talking about the American markets. Index funds in USA track indices which contain almost 500 to 5,000 companies. In the American market, the cost associated with other funds usually eats into the returns of the investor. In addition to the high fee structure of the funds, active management of these funds is not as effective since most fund managers find it difficult to beat the market with consistency. But these are the reasons for the popularity of index funds in other markets which are far more efficient and well-managed than the two market indices in India.

What about index funds in India?

If you are investing in India, then you must concern yourself with the market in the country so that you can make judicious decisions regarding your investments. The diminished presence of index funds in India is solely because it does not provide adequate returns. The two market indices, Nifty and Sensex, have a very small number of companies on the index. And this is clearly not indicative of the actual Indian market which is broader and more diverse. So if a company has potential but it is not big enough to reach one of the indices then it will not be a part of the portfolio. Similarly, if a big company has most of its shareholding held by promoters then it will not be able to find itself in one of the two market indices which mean that your index funds will not be able to take advantage of such well-performing companies. On the other hand, a fund manager for actively managed funds will see this as an advantage and add it to the portfolio. Because other countries have a stronger and more robust market, index funds are seen as a profitable investment in such markets. The fact that these markets usually perform well and actively managed funds in such markets often fail to reach the benchmark makes index funds a sensible investment for such markets. So Warren Buffet and Benjamin Graham were talking wisely about investment in their country. But since the Indian market is yet to reach competence in certain parameters, actively managed funds usually beat the market and perform better. A wise investor will see adequate reason to stick to actively managed funds in the Indian market.

What makes index funds less popular in India?

Now that we have established that indexing works in a few markets only, there are a few reasons why it is shunned by most investors in India:

The absence of adequate diversification

While Sensex may be considered as a barometer of the Indian market, it is not an ideal guideline for investment. The problem lies in ample diversification to make sure that the index includes companies from different sectors of the Indian market. At this time, Sensex does not have sufficient diversification in such terms. Important sectors like shipping, aviation, textiles, and tourism have not been adequately explored by Sensex. By limiting the sectors, it limits the chance of the index to mirror the actual Indian market. Even when a sector is represented by the index, the selection of the companies from the sector may not always be the best investment. Usually, large companies with liquid stocks find their way to the list of Sensex or Nifty’s index. But a wise investor will identify the potential of a company’s future and use more than just one parameter to invest in the company.

Holding on to underperforming stocks until the last minute

Since index funds rely on the index it is mirroring for buying or selling the stocks, these funds will usually include stocks that may be underperforming for a substantial period of time, till the company is not dropped out by Nifty or Sensex’s list of companies. The two indices experience a number of fluctuations throughout the day and there is no surprise in a company being dropped from the list to add a new, better performing one to it. While the working of these two indices makes sense, the problem lies in the fact that an underperforming stock may take up part of the share of your investment till the time it is on the list. Unlike actively managed funds, you do not have the option to do away with such companies by removing them from your portfolio.

Does not require Insight or Foresight

One of the things that is often considered to be a benefit of index stocks is the fact that it does not require an investor to continuously gauge the market. But what may be a benefit in other more established markets is a flaw for the Indian market. This is because fund managers or individual investors have the ability to wisely look into the past records of the company and its future potential to figure whether it will be a prudent investment or not. This helps them beat the market and gain better returns. Index funds, on the other hand, are devised to mirror the market, so the reality is that they would not be able to over-perform or under-perform when it is mimicking the market index. Indian investors will not be able to find satisfactory returns from such funds because of the fact that they perform at par with the market. While a conservative investor may feel this is good, studies show that other funds in India usually perform better than index funds.

 

They Buy High but Sell Low

Every time a company is removed from the list of the market index that the index fund is mirroring, stocks for that company will have to be sold. Since a company is removed mainly when it is under-performing, this means that you will be selling the stocks at a relatively lower price. On the other hand, the company that may have been introduced to the list will usually be a high performer. To comply with the characteristic of index funds, stocks for the newly listed company will have to be bought, which are usually at a higher cost. For the Indian market, buying high and selling low seems irrational; especially when the gains are not as substantial as other funds. Matching the weight of the market index is more suitable for dynamic markets where indices are put together with more parameters in consideration.

Innovative Indices are absent from the Indian Market

The Indian market presents two very basic indices that can be mirrored by index funds. The absence of dynamically managed indices makes it difficult for index funds to do well in India. Most countries where investors swear by index funds usually have innovative indices that they can take advantage of. Even though we have indices within the stock exchange, these indices are not available for investing which limits the potential of index funds. The Indian market is brimming with investing opportunities beyond these indices and when invested judiciously, an investment in actively managed funds can lead to a substantial amount of returns.

Performance

With the equity benchmark indices Sensex and Nifty making record highs day after day, a few passive mutual funds in India have returned more than 40% for the past one year. Interestingly, these passive funds have low expense ratios too, which may help the investors to achieve better returns. Another important aspect to note about these funds is that they do not aim to beat their respective benchmarks, but look to mimic the underlying index. For example, ICICI Prudential Next 50 Index Fund’s investment objective says, “The investment objective of the Scheme is to invest in companies whose securities are included in Nifty Next 50 Index (the Index) and to endeavor to achieve the returns of the above index as closely as possible, though subject to tracking error. The Scheme will not seek to outperform the Nifty Next 50. The objective is that the performance of the NAV of the Scheme should closely track the performance of the Nifty Next 50 over the same period subject to tracking error.”

When to invest in index funds?

Invest in Index Funds if:

You do not want to risk your money to a fund manager

If you do not have any faith in fund managers then investing in index funds may be suitable for you. No investment is immune from risks. Keeping in mind that fund managers may end up making the wrong choices or forecasting the wrong trend, other funds have a higher level of risk than index funds which are meant to automatically mirror whatever the market does. So, sidestepping the fund manager assumes paramount importance.

You do not want to pay too much for the costs

Passively managed index funds do not require a person to actively monitor the markets and make decisions regarding the portfolio. This means that the cost of managing these funds is fairly lower than other funds. If you do not want to give away your returns in the form of costs then you will find this to be a good investment. But market analysts usually find that what other funds lose out on cost, they usually make up on returns.

You want a broad exposure to the market

Sensex and Nifty incorporate those companies that are doing well and have an excellent reputation in the market. So if you are looking for exposure in the market, especially in stocks that carry a large market value, then begin with Index funds.

Things to consider as an investor

a. Risk

Since index funds map an index, they are less prone to equity-related volatility and risks. Index funds are amazing options during a market rally to earn great returns. However, you need to switch to actively-managed funds during a slump. It is because index funds may lose higher value during a market downturn. It is always advisable to have a mix of actively-managed funds and index funds in your portfolio.

b. Return

Unlike actively-managed funds, Index funds track the performance of the underlying benchmark in a passive manner. These funds do not aim to beat the benchmark but to just replicate the performance of the index. However, many a times, the fund returns may not match that of the index on account of tracking error. There might be deviations from actual index returns. Before investing in an index fund, you need to shortlist a fund which has the minimum tracking error. The lower the number of errors, the better is going to be the performance of the fund.

c. Cost

Index funds usually have an expense ratio of 0.5% or even less. In comparison, actively-managed funds have an expense ratio of 1% to 2.5%. The reason for cost disparity is that the portfolio of the index funds is not passively managed and the need for the fund manager to formulate any investment strategy does not arise. The real differentiating factor between two index funds will be their expense ratio. The fund having a lower expense ratio will give marginally higher returns.

 

d. Investment Horizon

Index funds are basically suitable for individuals who have a long-term investment horizon. Usually, the fund experiences a lot of fluctuations during the short-run which averages out in the long-run of say more than 7 years in order to give returns in the range of 10%-12%. Those who choose index funds need to be prepared to stick around at least for the said period to enable the fund to realise its full potential.

e. Financial Goals

Index funds can be ideal for achieving long-term financial goals like wealth creation or retirement planning. Being a high risk-high return haven, these funds are capable of generating enough wealth which may help you to retire early and pursue your passion in life.

 f. Tax on Gains

When you redeem units of index funds, you earn capital gains. These capital gains are taxable in your hands. The rate of taxation depends on how long you stayed invested in index funds; such a period is called the holding period. Capital gains earned on the holding period of up to one year are called short-term capital gains (STCG). STCG are taxed at the rate of 15%. Conversely, capital gains made on holding period of more than 1 year are called long-term capital gains (LTCG).  Owing to recent changes in budget 2018, LTCG in excess of Rs 1 lakh will be taxed at 10% without the benefit of indexation. If you plan to have an index fund in your portfolio, it is best to have a broad based index fund - an index that captures a large part of the market, such as a CNX Nifty 500.  The Goldman Sachs CNX 500 is one such fund.  If you are a beginner in stock investing, an index fund is a good idea to start with. It gives you exposure to a diversified portfolio at a very low cost.

Time for passive investing in India…

If Indian equity markets have indeed become more efficient over the years, why is it that active mutual funds continue to do better than passive funds? Why are active funds preferred over passive funds? After all if markets are getting efficient, then information asymmetry is becoming lesser. The fund managers should know as much as entire markets and no advantage can be drawn from any analysis.  So far, index investing has not succeeded because the market was not heavily institutionalised and large chunks of companies were not owned by professional fund management. This is now changing. Another huge factor which points towards the impending rise of passive investing is rising costs. Fund management costs have now gone through the roof. Actively managed funds charge up to three percent of total assets. This is something that will now start impacting returns in a way that is noticeable to investors. The next factor is the size of the funds. Indian equity funds have been seasonal and small. A small fund can opportunistically try many investments in midcap and smallcap companies that can yield returns that have a big impact on the portfolio. This is not possible for large funds. The Indian equity fund universe is now dominated by big funds. There are now more than fifteen funds that have more than Rs 10,000 crores. Seven-eight funds are close to Rs 20,000 crore. Such funds have no choice but to be large cap funds. They are finding it hard to beat the index consistently. They have a compelling performance track record over a long period and they have beaten the indices by a big margin. However, going forward, because of their size, because of the expenses they charge, and because of the growing institutionalisation of the market, they will not find it easy to outperform. So does that mean that if you are starting an SIP for ten years, you should do so in an index fund? Well, the case is not that strong yet. Over the last five years, the top five actively managed funds would have earned you one and a half times more than a Nifty fund and that is a big difference. However, it is something that an investor should keep a watch on. At some point in the coming five years, there will likely be a time when it will make sense to stop your SIP in an actively managed fund and turn to an index fund. We are heading in that direction, slowly but surely. Active funds still rule, but passive investing has a future.