There’s only one investment that Warren Buffett, the world’s most celebrated stock picker, plugs at every opportunity. That is a low-cost S&P 500 index fund. But unfortunately, this is one product that Indian investors, despite 1,800 funds on their menu, have no access to.

Investors in the developed markets are already fans of index investing, pouring billions into index and Exchange Traded Funds (ETFs) while cutting back on their purchases of active funds. This is what has transformed Vanguard, which operates the largest US S&P500 index fund, into a global Goliath with over $4 trillion in assets.

Not a hit

But index funds and ETFs remain a non-starter in India, managing only 4 per cent of the overall mutual fund assets. If you ask anyone from the mutual fund fraternity why index funds are so unpopular, they’ll instantly tell you that it is due to their poor show relative to active funds.

This is quite true. While active fund managers in the US have huffed and puffed to keep up with the S&P 500, a majority of active funds in India have managed to beat their index counterparts, some by big margins, in the last ten years.

But the big wins for active funds in India are as much a result of the low-quality index funds that they’re pitted against, as the stock selection skills of their whiz-kid managers.

There are three problems with the index funds and ETFs offered in India that make active managers shine by comparison.

Wrong criteria: Of the 60 index products in India, as many as 34 shadow narrow market indices such as the Nifty50 or Sensex30. These are no doubt excellent bellwethers to track if you are looking to capture stock market action on any given day. But no seasoned investor will agree that the Nifty50 or Sensex30 represent a great basket of stocks to own for fundamental investors.

The primary selection criteria through which stocks are swept into the Nifty50 or Sensex30 are liquidity, impact cost, free float market capitalisation and trading frequency. All these criteria are intended to ensure that these stocks are the most sensitive to daily gyrations in market prices and sentiment.

Whereas long-term investors in stocks often look for the opposite attributes — low volatility, steady and predictable growth in earnings, and sustainability of return on equity from the business. Given that trading activity is a far more important parameter for a company to make it to the Nifty50 or Sensex30 club, than its balance sheet strength, governance or business prospects, quite a few stocks with doubtful credentials make it to these indices.

Too much churn: Global ETF managers complain that India is a very difficult market to run good index funds because indices here are managed very much like active funds. A study of Nifty50 index changes in the last 15 years reveals that it has replaced an average of four stocks every year with the number shooting up to six stocks in some years. Ditto for the S&P BSE 200 index, where 20 plus changes are quite the norm, with as many as 60 stocks shunted out one year. The frequent chopping and changing makes index tracking a harrowing task for ETF and index fund managers, leading to a high tracking error.

Momentum-based: Most bellwether indices in India weight their constituent stocks based on either full or free-float market cap. As market cap is a function of stock prices, the most fancied stocks in any bull market keep increasing their clout in the index while out-of-favour stocks lose weight, and eventually get dropped.

Thanks to market cap weights, the indices also suffer from concentration risks. For instance, financial services now takes up a 36 per cent weight in the Nifty50, with just four stocks — HDFC Bank, Reliance Industries, HDFC and Infosys — accounting for a third of this index.

Active fund managers often manage to beat these indices through the simple expedient of staying off loss-making or poorly governed firms or owning more moderate weights, though such calls can also backfire (as they have done recently).

New kids on the block

True, Indian index products have of late moved beyond the Nifty50 and Sensex30 and cropped up around the new factor, strategy and thematic indices launched by the index providers. But many of these funds still present a sub-par option for fundamental investors.

For instance, a dozen or so ETFs now play on the Nifty Next50, Nifty100 or the S&P BSE100 indices. While these are less concentrated than Nifty50 or Sensex30 and have better return records, they continue to select stocks based on market capitalisation. ETFs mirroring the new strategy and thematic indices also suffer from similar constraints. The Nifty Value20 index would be a great bet for long-term investors seeking to buy bargains, if its constituents weren’t drawn only from the Nifty50.

Now, many of these problems could be resolved if the fund industry were to launch ETFs mirroring the S&P BSE 500, a far more diversified index representative of the whole market. But fund managers cite poor liquidity and market depth in the stocks beyond the top 200, as hurdles to operating a S&P 500 fund in India.

Given the yawning gaps in management fee between the current crop of actively managed equity funds in India (which charge 1.75 to 3 per cent of assets) and ETFs (available for as little as 0.10 per cent), there are strong business reasons for existing AMCs not to try too hard with index products.

Why a Vanguard

This stalemate suggests that SEBI should seriously look at introducing more competition into the indexing space to drive more innovation. There’s no reason why the task of designing and launching new indices should remain the preserve of two stock exchanges; nor is there reason why AMC licences cannot be granted to specialist ETF-focussed firms.

Attracting Vanguard to the Indian shores or incubating a home-grown Vanguard would have three clear benefits for investors at large. One, young millennials looking to test out equities need not struggle to make sense of active funds. If they are keen to buy funds through Paytm, they can buy index funds without making big mistakes on fund choices that will cost them dear.

Two, SEBI does not need to wrestle with a reluctant industry on driving down costs or promoting direct plans. Once a low-cost S&P 500 fund is on tap, investors who do not want to pay for advice can directly go to such funds without choosing from hundreds of direct plans.

And, finally, retirement funds in India such as the NPS and EPFO, which are struggling to deliver a good equity experience to retail investors at bargain-basement fees, can simply take the S&P 500 route to their equity portfolios.

This will not just address their skill gap, but also take away the discretion for the government of the day to force them into sub-optimal stock purchases, when the disinvestment programme is in need of a lifeline.