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Aarati Krishnan

IS THIS the right time to invest in an index fund? This is a question many investors may be posing right now, with the S&P CNX Nifty, the widely-tracked market index, having shed close to 47 per cent of its value from the peak of February 2000. For investors looking to build a nest-egg in equities for the long term, this does appear to be a good opportunity to begin investing in equity.

Index funds (equity funds that passively mimic a market index) may appear an easy choice for investors who have a slew of equity funds to choose from. After all, index funds allow you to neatly sidestep the risk of poor stock selection by a fund manager. Financial textbooks advance a host of other arguments in favour of index funds — low costs, predictability and diversification.

But an analysis of fund performance over the last six years (from January 1997 to November 2002) shows that this may be quite the wrong time to invest in an index fund. Instead, actively managed funds with a good track record may be the preferred alternative. Zurich India Equity Fund, Franklin India Bluechip, Templeton India Growth Fund and Alliance Capital Tax Relief would be among the best choices. Here is the case against index funds:

Active funds have easily beaten the index over a six-year period: Between January 1997 and now, six out of ten actively managed equity funds outperformed the S&P CNX Nifty (the benchmark for most index funds), and seven outpaced the BSE Sensex. That is not all.

The top ten funds ran far ahead of these indices. An investor who put Rs100 in Alliance Capital Tax Relief in January 1997 would find his investment now worth Rs 772 (assuming reinvestment of dividends). In fact, any of the top ten funds would have more than doubled his money.

Whereas, an investor who parked his money in the S&PCNX Nifty would be left only with Rs 117, even factoring in dividends from Nifty companies. A similar investment in the Sensex would be worth Rs 96 today.

And all the index funds which are currently in operation are modelled either on the Nifty or the Sensex. (Actual returns from index funds have been marginally different, but this gap is likely to narrow over time. See accompanying piece.) True, few active funds have consistently beaten the index year after year. But a majority of the funds have made up for a couple of bad years with a few years of good performance, managing to outpace the index if held for over 5 years.

Plenty of action outside index stocks: If several active funds have beaten the Nifty and the Sensex hand over fist, this is because the Sensex and the Nifty (comprising relatively few stocks) do not fully capture the action in a significant section of the market. While both these indices represent a large portion of the traded market capitalisation, the stocks they leave out often outperform the index.

In 1998 and 1999, active funds focussed on FMCG, pharma and IT stocks registered impressive returns, while the indices were weighed down by cyclicals. In 1998, nine out of 10 active funds beat the Nifty, and in 1999, eight of 10 funds did better.

This is not a temporary phenomenon, either. In the first ten months of 2002, again, eight out of 10 active funds beat the Nifty.

While Sensex and Nifty were weighed down by large-cap, "A" group, stocks, active fund managers capitalised on the sharp rally in several small and mid-cap stocks to make impressive gains in 2002.

Active funds not so hot at spotting bull market reversals: After a stellar performance in 1999, most active funds trailed the Nifty in 2000, because of their overweight positions in IT stocks.

In 2000, eight of ten active funds registered higher value erosion than the Nifty. The position was only slightly better in 2001.

This suggests that index funds may be a better bet than active funds when there is a sharp correction from a bull market. But if an investor is indeed in a position to foresee a bear market, he would be better off pulling out of equities and holding cash or, better still, switching to debt.

Second, while investors who park money in an active fund for two or three years may bear the brunt of a fund's underperforming the index during that period, investors who stay with the fund for five or six years may have an opportunity to make up as the fund's performance evens out.

Limited diversification: One of the conventional arguments in favour of index funds is that they offer diversification. True, while active funds may be overexposed to a few stocks or sectors, index fund managers are not prone to such temptations. This argument holds good only when the market index represents a well-diversified basket of securities. But both Nifty and Sensex are influenced by relatively few sectors and stocks. Just two stocks — Hindustan Lever and Wipro — carry a combined 20 per cent weight in the Nifty. And just three sectors — FMCG, oil and gas and IT — account for 60 per cent of the Sensex.

In fact, the high sectoral and stock concentration of these indices makes it relatively easy for active fund managers to outpace the indices.

In 2002 so far, most active funds have beaten the Sensex and the Nifty merely by remaining underweight in FMCG stocks and overweight in cyclicals. In fact, after the excesses of 1999, many active funds now set internal ceilings on their sector- and stock-specific exposures. This should ensure reasonable diversification.

Low costs, a myth? : One of the key arguments advanced in favour of index funds in the developed markets is that they have low-cost structures. In theory, index funds entail lower investment management fees than active funds and save on brokerage and transaction costs through passive portfolio management.

However, in the Indian context, this is not necessarily true.

In many cases, investment management fees charged for index funds are not much lower than those charged for active funds. This is not all.

Quite a few index funds recently imposed an entry load of 1 per cent on fresh investments. This could further trim the effective returns in an index fund.

Given the frequent changes to index constituents, the transaction costs for index funds may not be that low in the Indian context.

Since January 2002, the composition of the S&P CNX Nifty has seen seven changes. Obviously, all the index funds tracking the Nifty would have had to rejig their portfolios on each of these occasions.

What should investors do? : The above findings suggest certain investment strategies:

Investors who see little downside from the prevailing level in the equity market should build equity exposures through actively managed funds, rather than index funds. This is especially true for investors who are investing for a five-year period or more.

Investors who see a substantial downside in the market should book profits on their active funds and switch to cash or a debt fund.

For the vast majority of investors, it would be quite difficult to conclusively judge or predict market direction. But such investors can base their investment decisions on positive and negative target returns.

If the market indices have crashed by 40 or 50 per cent from their peak, it may be time to start building exposures in actively managed equity funds. Or, if an active fund held by you has appreciated by 50 per cent, it may be time to book profits and switch.

If you are willing to take some risks of capital losses on your portfolio you could switch to an index fund.

This would ensure that you do not lose out on any further appreciation in equities, while guarding against a very sharp downside. If protection of capital is your primary objective, you may be better off switching to a cash or debt fund, once you book profits.

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