The Hindu Business Line : Index funds struggle to beat benchmarks

BL Research Bureau Investors in index funds may be a disappointed lot in 2007, despite the breathtaking rally in the bellwethers. Open-end index funds have struggled to keep up with their benchmarks this past year.

The CNX Nifty notched up a 53 per cent gain in 2007. But, of the 11 open-end index funds tracking the Nifty, six have returned less than 51 per cent.

Four of these funds significantly lagged the Nifty, managing returns of 42 to 48 per cent and trailing the index by 5-11 percentage points. Index funds are usually expected to contain their ‘tracking error’ (the difference between the fund’s returns and that of the index) to 2 percentage points or less. The ‘tracking error’ is caused by transaction costs, operating expenses, and management fee incurred in running the fund, apart from the cash position held in the portfolio.

Of the index funds tracking the Sensex, three out of six funds have been under-performers and fell short of Sensex returns by four to nine percentage points. Index funds from Reliance Mutual, HDFC Mutual, and LIC Mutual Fund were the key ones that under-performed.

Redemption pressures for some of the open-end index funds, big-ticket changes in both the Sensex and the Nifty constituents this year, as well as high intra-day volatility in the index stocks are cited as some of the reasons why index fund managers found this a challenging year.

Outflows from an open-end index fund may prompt it to hold a larger cash position, reducing its ability to participate in a sharp market rally. “This is an aberration that tends to amplify in funds that reduce in size after launch,” explains a spokesperson for Reliance Mutual Fund. Reliance’s index fund is among the smallest ones in operation, with an asset size of Rs 4 crore under the Sensex and Nifty plans in November.

However, Mr Rajan Mehta, Executive Director of Benchmark Mutual Fund, feels that index funds can actually deliver better returns than their benchmarks due to dividend receipts from the companies making up the indices. “Dividend receipts on the Nifty companies have the potential to add up to 1 percentage point to the index fund’s returns,” he points out.

Some of the open-end index funds, as well as exchange traded funds (ETFs) tracking the indices have managed to match or even better the index performance this year. ETFs such as Benchmark’s Nifty BEES and UTI Mutual’s SUNDER sport one-year returns of slightly over 54 per cent, which is higher than the index they track.

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