At first glance, it would seem that most equity mutual funds are sitting pretty well on profits—last year, 99.03 per cent of active funds gave positive returns. Dig deeper and you find one in three active funds underperformed the bellwether Sensex. As compared to the Sensex’s returns of 76 per cent, some actively managed equity funds returned just 41 per cent. As in any bull market, the rising tide lifted most stocks and so it was not that difficult for fund managers to chalk up a positive performance. Yet, over the long run, most fund managers find it difficult to beat the averages consistently every year, year on year. The funds that are leaders of today could be the laggards of tomorrow.
In the quest for market-beating performance, mutual fund investors could often chase the top performers and churn their fund portfolios, but just as often find that these funds did not perform well the next year. In such a scenario, it’s best to balance out your mutual fund portfolio by including index funds—funds that only track their benchmark index.
Index funds are passively-managed funds which invest in those securities that lie in their benchmark indices and in the same proportion. There are mainly two types of funds: one that holds all the stocks which are the constituents of the chosen index in the same proportion, and the other that follows the sample of benchmark index. In India we have two widely-tracked indices: the NSE-Nifty and the BSE-Sensex. Around 34 schemes track these two indices. Out of these schemes, six are Exchange Traded Funds (ETFs). Among the rest, 19 are Nifty-based index funds, while the remaining track the Sensex. A few of them track some sector-specific indices, such as the banking and PSE indices.
Active versus passive
Index funds are still not very popular in India as they are in most developed countries. That’s because there are valuation gaps in the stockmarket and pockets where the fund manager can use his acumen to pick outperforming stocks. In the US, there are not many valuation plays that fund managers can exploit as the market is more mature and well-researched. On the other hand, mutual fund distributors were selling more actively-managed funds than index funds. But with the new distribution structure, the onus will be on investors to select funds, if they don’t want to go through a distributor. However, you need to pay the distributor for his services. It is not a very easy task to choose the right fund among around 250 actively-managed funds on your own. If you are not that much investment-savvy, or do not have the time and the resources to track the hundreds of actively-managed MF schemes that are available, you can add an index fund to your portfolio. This should help you cover the broad market.
The beauty of an index fund is passive management and, because of this, its low cost structure. If you look at the returns, index funds have performed equally well vis-a-vis other actively-managed funds. The average return of index funds on a 5-year and 3-year basis is 18.19 per cent and 6.19 per cent respectively, whereas the average return of an actively-managed equity fund are 20.92 per cent and 8.52 respectively, for the same period, on the BSE. Among index funds, some have delivered as high as 23 per cent compared to benchmark returns of 20.79 percent. Some of the actively managed funds have given returns as low as 5 per cent on a 5-year basis, which is far lower than passively-managed index funds.
Lower expenses
Selection of the right index fund is not rocket science. It is far easier than the selection of an actively-managed equity fund. Here, you need to look at the two main parameters: expense ratio and the tracking error. The lower the expense ratio, the better is the fund. For instance, assume you invest Rs 50,000 each in ING Nifty Plus and Franklin India Index-Nifty, for a period of 20 years. Note that while ING Nifty charges 2.5 per cent towards expenses, Franklin India Index charges 1.5 per cent. Assuming that the market grows by 15 per cent for the next 20 years on a compounded basis, Franklin India Index will yield you Rs 6,29,342, while ING Nifty will yield you Rs 5,27,254. That is a clear difference of Rs 1,02,088, or 19 per cent.
The objective of index funds is to achieve the return of index they are tracking so, usually, the returns from index funds are almost the same. But, in many cases, you will find the return of index does not match the index fund you have invested in. There are plenty of reasons for this. The stocks that the fund has invested in may have declared a dividend. In other cases, the cash levels and expense ratios that the fund holds might be different. This leads to a mismatch between the net asset value of the index fund and the closing values of the index. This mismatch is also called a tracking error. The better-managed index funds are the ones that have the lowest tracking error.
You just need to look at the expense ratio of the fund and the actual return from the fund versus its benchmark return. Always go for funds having the least expense ratio and less difference between the fund's return and the benchmark's return. Usually index-based ETFs have the least expanse ratio. On an average it is around 0.71 per cent, which is around 50 per cent less than non-ETF index funds. If you are a tech-savvy investor and looking for index funds, you may choose to go the ETF way. Alternately, you could opt for non-ETF index funds.
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