The Hindu Business Line : Index funds do not really lower risks

THE Pension Fund Regulation and Development Authority (PFRDA) has suggested in its draft proposal that pension funds should only invest in index funds. The reason is that non-index funds run active risk.

This is the risk of under-performing the market. Such a performance evaluation of active funds is not correct. Besides, index funds run a high risk in the Indian market, as they are vulnerable to market manipulation. Traders can, for instance, move Reliance Industries and ONGC to serve their objectives. Constructing a long-term portfolio on such an index is highly risky.

The PFRDA should encourage professional money managers to run active funds. That way, pension fund beneficiaries can enjoy a high risk-adjusted return over the targeted investment horizon.

Indexing: Studies in the US have shown that index funds on an average perform better than the active funds. The rationale is this: All investors together own all stocks in the market.

So, their total return would match the market return. Assuming a normal distribution, this means half the investors outperform the market while the other half underperforms.

But a good proportion of fence-sitters will join the universe of underperformers if brokerage commissions are included.

Of course, there may still be portfolio managers who comfortably outperform the market. Manager selection then becomes an important factor.

Empirical evidence has shown that investors are not good at manager selection. Since choosing a wrong fund could prove very costly, it is suggested that investors choose an index fund.

It is a moot point whether the PFRDA has suggested investment in index funds based on this rationale. In any case, this argument does not hold water in India. The reason is that our country has only a handful of fund-houses.

Manager selection may not really be a problem. Besides, index funds are at the mercy of the whimsical market operators who may choose to push the index in the direction they want. This exposes the index fund's portfolio to high risk.

Active vs passive risk: Diversified equity funds in the country have outperformed the index funds by 10 percentage points for a five-year period. That is, indeed, a high margin.

A longer investment horizon could only widen the gap. The reason is simple. Index funds have to invest in stocks that constitute the index. What if some index stocks are underperformers? Obviously, the downside risk for index funds is high.

Worse, the upside potential for index funds is limited, especially because the Indian market has often tended to be a sector play. Textile sector, for instance, is the current favourite. Tech stocks were the favourite in 2000. Index funds unlike active funds cannot become overweight in such stocks.

Such funds also deny investors the benefits of asset allocation. This column dated August 30, 2004 argued the merits of asset allocation between momentum and value stocks in an equity portfolio.

An active manager can choose stocks such that the portfolio contains value picks for the long-term and momentum buys for the shorter horizon. Such investing will improve asset growth because profit taking in momentum stocks can be reinvested for more gains.

Finally, comparing an active fund to the broad market index is not correct. An active fund may follow a certain investment style, say, mid-cap value.

Proper performance evaluation requires comparing the fund's actual performance to its style benchmark. Of course, there could be instances where the style benchmark itself underperforms the broad market.

The mid-cap style index may under-perform the S&P CNX Nifty by, say, 3 percentage points. In the long run, however, active managers should outperform the broad market to justify the high management fees. So, active funds could deliver superior risk-adjusted returns.

All these factors suggest that index funds do not really lower risk. It is best that the PFRDA provides several investment styles for the pension beneficiaries to choose from. This can help the beneficiaries improve their long-run risk-adjusted return.

(Feedback can be sent to bvenky@thehindu.co.in)

More Stories on : Mutual Funds | Insight | Mark To Market | Pension Plans

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
RBI's gentle squeeze

Trends in patent and trademark law

Stock taking by the Plan panel

Tasks before the Twelfth Finance Commission — A tough balancing act indeed

Distress from stress

Index funds do not really lower risks

Investors, frogs and Yellowstone effect

Review of RBI Act

Trade policy