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Aarati Krishnan

IF YOU believe that the Sensex or the Nifty are about to break from the past and sail ahead of their all-time highs, investing in index funds may appear to be a tempting prospect now. But one should first consider investing in actively managed, diversified equity funds with a good long-term record.

For investors with a healthy appetite for risk (you need one to stay invested in the markets at these levels), actively managed funds such as Franklin India Bluechip Fund, Templeton India Growth Fund, HDFC Equity Fund may be among the options to consider.

Modest show: There was a significant divergence in the performance of index funds in 2003. In a surprising trend, most of the index funds which tracked the Sensex trailed those which track the Nifty by a significant margin.

This is surprising because 2003 was a year in which the Sensex, with returns of 74.5 per cent marginally outperformed the Nifty, which returned 73.8 per cent.

One explanation for the significant tracking error on the Sensex funds could be the substantial changes in the Sensex constituents this year. With the Sensex changing over to a free float index, index fund managers were probably forced to replace a significant portion of their portfolio enhancing transaction and impact costs. Within the Sensex tracking funds, Franklin Templeton Index fund, had the lowest return of 66.1 per cent, while UTI's Master Index Fund had the highest return of 76.8 per cent.

Within the Nifty funds, most funds registered a positive tracking error, notching returns that were up to 4 percentage points higher than the Nifty's returns. Here, the returns ranged from 72.9 per cent on the Nifty Benchmark exchange traded fund to 78.6 per cent on the Franklin Templeton Index Fund-Nifty plan.

Investors in the index funds which paid out dividends during the year, faced with an opportunity loss. Having pulled out part of their funds mid-way during the rally, they are likely to have earned lower returns than those who stayed invested.

Easily beaten: In 2003, as in the preceding bull markets, index funds have been beaten by the majority of actively managed funds. About 7 out of every 10 active equity funds , beat the narrow market indices such as the Sensex or Nifty.

What is more, the margin by which diversified funds have beaten the index funds is large. While the best performing index fund (tracking the Nifty or Sensex), managed a return of 78.5 per cent, the top performing equity fund (Franklin India Prima Fund), managed a return of 165 per cent. Prima Fund benefited from its mid-cap focus.

But even funds with a large-cap bias, such as the Franklin India Bluechip Fund, Templeton India Growth Fund and HDFC Equity Fund have generated return of over 100 per cent in 2003, easily outpacing the indices.

Downside protection: Index funds are usually believed to offer better protection from a downside in markets than actively managed funds. As the argument goes, if you are invested in an index fund, your downside is restricted to the fall in index levels.

But if a fund manager has aggressively picked stocks outside of the index, there is a possibility of the NAV falling much more than the index.

In the past, this has been observed in the Indian markets as well. The majority of active funds outpaced the Sensex and the Nifty in the bull market of 1999. But during the market reversal of 2000, the majority of actively managed equity funds lost more value than the indices, some losing as much as 60 per cent of their NAV. This would seem to suggest that investors seeking downside protection should switch to index funds.

But this logic may not hold good this time round. For one, some of the big losses on equity fund NAVs in 2000 were due to concentration in IT, media and telecom stocks. But most equity funds today have rigid ceilings on their stock and sector specific exposures. Equity fund portfolios thus sport a more diversified look, which may help restrict the losses in the event of a market reversal.

Second, given the sharp run-up across the range of stocks over the past year, generating returns from the current levels would seem to call for some careful stock picking. Therefore, careful stock selection may deliver better returns going forward, than passively staying with the index stocks.

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