The Hindu Business Line : Indian markets becoming `efficient'

Index funds are, by definition, passive investments in stocks mirroring exactly the composition of a popular index such as the Sensex, Nifty, FTSE-100 or the S&P 500. So the returns from an index fund will track the index, which it chooses as its benchmark (less fees and expenses).

Managed funds depend on the skills of their fund managers to choose stocks, the intent being to outperform popular indices (or what amounts to the same thing - the market). Naturally, active management is costlier - managed funds typically charge more fees than index funds.

But with what results? Academic research with historical and cross-sectional data has more or less conclusively proved that managed funds have not done better than the index for any sustained period of time. An investor is better off simply investing in index funds, assured as he is of at least the index return. This is the theory of efficient markets.

In India, managed funds handily beat the index till the start of the current bull run in 2002-03. In the last three to four years, given the several fold rise in the Sensex and Nifty, managed funds have found it hard to match the performance of the indices. Besides, the volatility has been stomach-churning. The last three years have seen four occasions when the market fell thousands of points in days only to bounce back to even higher levels.

An index fund manager (and investor) can just sit back and relax knowing his return cannot fall below the index. The active money manager must break his head and guess whether the fall is purely temporary or portends worse things to come. He usually gets it wrong and that is reflected in the submarket returns from almost all managed funds in the last year or two.

What, in fact, we need is many more of exchange - traded funds (ETFs), which are even cheaper than index funds. In contrast to (open-ended) index funds, ETFs do not offer entry and exit through the fund but are listed and traded on stock exchanges (hence the name exchange - traded). They do not incur the cost of day-to-day liquidity management in an open-ended index fund, which must handle daily sales and repurchases of redeeming investors (including savvy ones trying to time the market).

Competition reduces returns. The deteriorating performance of Indian mutual funds is clearly because of mushrooming fund managers researching and chasing the same stocks, significantly shrinking undervalued opportunities. This trend can only strengthen over time. An Infosys, a Suzlon, Pantaloon or an IVRCL is a rare phenomenon and even those lucky enough to have invested in one these companies would hardly expect to repeat the success in their lifetime.

Of course, the search for such gems will continue. And that is what keeps fund managers on their toes and the market efficient.

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