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Aarati Krishnan

UNTIL recently, not too many choices were available to those keen on investing in index funds in India. But several fund houses have launched passive index products over the past year, with five completing one year of operations.

These are: Franklin Templeton India Index Fund (formerly Pioneer ITI Index Fund, offering both Sensex and Nifty Plans), Franklin India Index Fund, UTI Nifty Index Fund, UTI Master Index Fund and IDBI Principal Index Fund.

How closely have these funds managed to replicate their underlying indices? Not very, it would appear.

If one computes the accumulated tracking error (the percentage by which returns from the fund deviate from the underlying index) for all these funds over their holding period, just one, Franklin India Index Fund, managed to keep its tracking error to within 1 per cent.

Over its holding period, the fund's returns beat that of the Nifty by 0.91 per cent. For all the other funds, the returns over the holding period deviate from that of the underlying index by over 1 per cent.

Four of the six index funds have a positive tracking error. That is, they generated higher returns than that of the index.

The widest divergence was in Franklin Templeton India Nifty Plan. This fund lost just 5.7 per cent in value since its launch, while the Nifty lost 10.31 per cent over the same period.

This large deviation appears to have arisen mainly because of the fund's investments in the Nifty futures, which helped the fund hedge its portfolio. On the other hand, the fund's Sensex Plan has a positive tracking error of 1.01 per cent.

While the fund probably cannot be faulted for using arbitrage opportunities available in the futures market, given this "active" management of the portfolio, it cannot be strictly compared to its competitors.

At the other end of the spectrum, the UTI's Master Index Fund trailed its underlying index, the BSE Sensex, by 4.73 per cent over its entire holding period (since 1998).

The fund's NAV lost 8.6 per cent since launch, while the Sensex lost 3.8 per cent. The IDBI Principal Index Fund has also accumulated a tracking error of 1.46 per cent since its launch.

How do funds acquire such a high tracking error despite faithfully replicating the index? Well, transaction costs could be one factor.

After all, index funds do have to incur brokerage and other costs to make changes to their portfolios in line with those in the index; and these are bound to dent effective returns.

The lack of depth in the Indian market can lead to rather high transaction costs.

The expenses incurred by the funds on investment management fees and recurring expenses, such as advertising, investor communication and administration costs, could also cut into effective returns.

Though these expenses may take away only a small proportion of the returns each year, the compounding effect could ensure that they amount to a significant sum over the years.

Many of these problems are, however, a function of an imperfect equity market. Over time, as more fund houses launch index products, competition is bound to whittle down the expense ratios of index funds.

Already, quite a few fund houses, such as Birla Sunlife, HDFC Mutual Fund, IL&FS Mutual Fund and PruICICI Mutual Fund, have launched passive index products over the past six months.

Benchmark Mutual Fund, a new entrant to the market, has made its debut through an exchange-traded fund (a passive index fund listed on the stock exchanges and tradable on a real-time basis).

Exchange traded funds boast of lower cost structures than the typical index fund and may help investors minimise tracking error.

One desirable development for investors would be the launch of index funds that track the broadbased market indices, such as the S&P CNX 500 and the BSE 200.

Since several of the present disadvantages of index funds stem from the narrow composition of the Sensex and the Nifty, such funds may help investors capture broad market trends more accurately through index investing.

But this may be difficult at present. Given the lack of liquidity in the bulk of the small- and mid-cap stocks, an index fund pegged to a broadbased index may find it difficult to push through transactions without incurring high impact costs.

Indian investors may, therefore, have to wait some time longer before they can invest in index funds that actually meet the expectations set forth in financial textbooks.

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