Big Story | Decoding index funds

Passive investing in India has been gaining ground, albeit at a slow pace. Over the past three years, the AUM (assets under management) of passively managed equity funds, including index funds and equity ETFs (exchange-traded funds), have more than doubled, thanks to the increased interest from provident funds, insurance companies, corporates and also from retail and HNI (high net-worth individual) investors.

Index funds seek to replicate the performance of the underlying benchmark without the active management by fund managers.

They imitate the portfolio of an index (say, Nifty 50) by investing in stocks that are part of the index in the same proportion as in the index. The other variant, ETFs, are also passively managed mutual funds traded on BSE and NSE just like equity shares. On the other hand, actively managed funds aim to outperform their benchmarks with the help of the fund managers. With no active management, index funds and ETFs have much lower charges than actively managed funds. For instance, the average expense ratio of the regular plans of active large-cap funds as on May 2020 was 2.3 per cent, and that of index funds and ETFs was 0.8 and 0.2 per cent, respectively.

Index funds and ETFs are good options for investors wanting index-linked returns. Investors new to the equity market can also consider the index funds route.

The reasons for investing in passive funds have grown stronger of late due to the underperformance of actively managed large-cap funds against their benchmarks such as the Nifty 50 TRI and the Nifty 100 TRI, due to the move towards TRI-based (Total Return Index) benchmarking from early 2018, SEBI’s recategorisation norms that standardised the allocations in large-cap funds, stellar performance of a few stocks in the index and higher expenses attached with actively managed funds, among others.

The chart depicts the number of funds in the actively managed large-cap category that has outperformed their benchmark — the Nifty 100 TRI. For instance, in June 2015, 15 out of the 22 funds, or 73 per cent of the large-cap funds, outperformed the Nifty 100 TRI, while in June 2020, only three out of the 27 funds, or 11 per cent of the funds, generated higher returns than the Nifty 100 TRI. This analysis is based on the five-year rolling returns from the past 10 years’ NAV history.

While passive funds in India are largely dominated by institutional players, they have found favour with retail investors, too (mostly in index funds). AMFI (Association of Mutual Funds in India) data show that retail money accounts for one-fourth of index funds’ AUM.

We take a closer look at index funds and factors to be considered while investing in them.

The kitty

While with index funds, your choices are limited when compared with actively managed funds, there are currently 35 index funds in the market, tracking various indices.

You have index funds based on the Nifty 50 (15 funds), the Nifty 50 Equal Weight (one), the Sensex (five), the Nifty Next 50 (six), the Nifty 100 (one), the Nifty 100 Equal Weight (two) and the Nifty 500 (one). Banking sector, mid-cap, small-cap and S&P 500 index funds are also part of the offering.

While selecting index funds you must consider your risk appetite, and the expense ratio and the tracking error (TE) of the fund.

The decision to invest in an index fund should be made based on the composition of the index it tracks and its risk-reward behaviour over the long term. For instance, funds tracking the Nifty 50 and the Nifty 100 provide investors an opportunity to participate in large-cap stocks while mid- and small-cap index funds give access to the emerging and high-growth segments. Equal-weight index funds introduce you to an alternative method to investing in index stocks with lower concentration; opting for the S&P 500 index fund offers you exposure to the US market. Hence, you can select index funds based on your risk profile and requirement.

The biggest factor favouring index funds and ETFs is their lower expense ratios that help increase returns due to the compounding benefit. Hence, compare expense ratios within the index funds of a category, before investing.

Also, the efficacy of passive investing is measured through the TE, which shows how closely an index fund tracks its chosen index.

In simple terms, TE is the difference in returns between an index fund and its benchmark, with index funds with lower TE being preferred. TE may increase mainly due to the fees and expenses of the fund, corporate actions, cash balance, changes to the underlying index and regulatory restrictions.

Nifty 50, Sensex 30 index funds

These index funds track the broader indices constituting large actively traded stocks from diversified and leading industries.

There are 15 Nifty 50 and five Sensex index funds available currently.

The Nifty 50 is one of the most traded indices in the world and the top-traded derivative index in India. It captures approximately 67 per cent of the float-adjusted market capitalisation of the listed universe in India.

Banks, software, petroleum products, consumer non-durables and finance are the top sectors having exposure of 26 per cent, 15 per cent, 13 per cent, 12 per cent and 10 per cent, respectively, in the index.

Our take: If you are a long-term investor and looking to ride the broader market movement, Nifty 50 index funds are a right choice.

Choose a Nifty 50 index fund with the lowest expense ratio and start an SIP.

Within the index funds tracking the Nifty 50, UTI Nifty Index Fund, HDFC Index Fund - Nifty 50 Plan and ICICI Prudential Nifty Index are the schemes that have relatively low expense ratios and TEs, and higher corpus.

Among the Sensex index funds, HDFC Index Fund - Sensex Plan scores on all aspects.

Investors who feel that the Nifty 50 is skewed towards a handful of larger stocks, can consider investing in equal-weight index funds. Equal-weight index funds allocate evenly across sectors and stocks that form a part of the Nifty 50. It is the simplest form of smart-beta strategy. Currently, DSP Equal Nifty 50 Index Fund follows this strategy.

Nifty Next 50 index funds

There are six index funds currently tracking the Nifty Next 50 representing 50 companies from the Nifty 100 after excluding the Nifty 50 companies.

Our take: The Nifty Next 50 enables you to invest in stocks that have the potential to become part of the Nifty 50 Index in the future.

Over the past five years, 14 stocks have moved to the Nifty 50 from the Nifty Next 50. On the other hand, most stocks that dropped out of the Nifty 50 have part of the Nifty Next 50.

Past data suggest that the Nifty Next 50 outperforms the Nifty 50 over the long run. For instance, over the past 10 years, the Nifty Next 50 and the Nifty 50 delivered a compounded annualised return (CAGR) of 10 per cent and 8.4 per cent, respectively.

Currently, growth stocks with a defensive bias appear to carry higher weight in the Nifty Next 50 than in the Nifty 50.

For instance, in the Nifty Next 50, the weight of consumer non-durables and pharma is 20 per cent and 16 per cent, respectively (as of April 2020), while in the Nifty 50, the weight is 13 per cent and 5 per cent, respectively.

Also, the Nifty Next 50 provides you access to the new and untapped insurance sector (16 per cent) which is not part of the Nifty 50 index.

ICICI Prudential Nifty Next 50 Index Fund is a top performer in the category.

Nifty 100 index fund

Currently, Axis Nifty 100 Index Fund alone tracks the Nifty 100, capturing the entire large-cap universe in the market.

Our take: The Nifty 100 essentially carries a combined portfolio of the Nifty 50 and the Nifty Next 50. You may argue that instead of investing in Nifty 50 and Nifty Next 50 index funds separately, you can opt for a single Nifty 100 index fund.

But under the Nifty 100, the weight assigned to Nifty 50 stocks is around 86 per cent, while for Nifty Next 50 stocks, it is just 14 per cent (as of April 2020). Hence, it makes more sense to hold both Nifty 50 and Nifty Next 50 funds instead of a Nifty 100 fund in your portfolio.

There are two equal-weight Nifty 100 funds available in the market.

Mid- and small-cap index funds

Only Motilal Oswal Nifty Midcap 150 Index Fund and Motilal Oswal Nifty Smallcap 250 Index Fund, respectively, track the mid- and small-cap indices.

Our take: Historical data suggest that passive investing works better in the large-cap segment. In the small- and mid-cap segments, fund managers have been able to outperform the indices significantly.

For instance, over the past 10 years, actively managed mid- and small-cap funds posted a CAGR of 11.2 per cent and 9.3 per cent, respectively, while the Nifty Midcap 150 and the Nifty Smallcap 250 delivered 9.6 per cent and 5.5 per cent, respectively.

Hence, these funds may not be ideal for the core portfolio of investors.

However, investors wanting to set up a dedicated index fund portfolio may consider these schemes.

Bank Nifty index fund

Only one fund, Motilal Oswal Nifty Bank Index Fund, tracks the Nifty Bank as its benchmark.

Our take: Over the long run, both active banking sector funds and the bank index have delivered identical returns. Investors with a high risk profile who are willing to take the sectoral risk can consider investing in the index fund through the SIP route.

Nifty 500 index fund

The Nifty 500 represents the top 500 companies based on full-market capitalisation from the eligible universe. The index covers more than 95 per cent of the listed universe at NSE in terms of full-market capitalisation.

Motilal Oswal Nifty 500 is the only fund that tracks the Nifty 500 currently.

Our take: The Nifty 500 is a far more diversified index and representative of the whole market. The weight of the Nifty 50, the Nifty Next 50, the Nifty Midcap 150 and the Nifty Smallcap 250 indices in the Nifty 500 is 71 per cent, 11 per cent, 13 per cent and 5 per cent, respectively. The index’s exposure to large-, mid- and small-cap stocks is 81 per cent, 13 per cent and 6 per cent, respectively.

Hence, the portfolio constitution of the Nifty 500 is more or less similar to that of active large-cap funds, but with far more diversification and less churning.

The Nifty 500 index fund can be part of any investor’s portfolio.

S&P 500 index fund

Motilal Oswal MF recently launched an S&P 500 index fund that tracks the S&P 500, which is widely regarded as the best single gauge of large-cap US equities. The index measures the performance of the leading 500 companies listed in the US and covers approximately 80 per cent of the available market capitalisation.

Our take: The fund provides Indian investors an access to the world’s largest and well-known companies. It can be a hedge against rupee depreciation. The S&P 500 has a very low correlation with the Indian equity market, providing an opportunity for diversification.

Ideally, the fund can form 5-10 per cent of your portfolio. You may also consider a fund of fund (FoF), Motilal Oswal Nasdaq 100 FoF, which invests predominantly in Motilal Oswal Nasdaq 100 ETF.

Note that all international funds are treated as debt funds for taxation purposes.

Index funds vs ETFs

Index funds score over ETFs on various counts. Liquidity has been a major issue when trading in ETFs.

But as index funds are directly bought and sold from AMCs (asset management companies), this would not be an issue.

Demat and broker accounts are mandatory while transacting in ETFs on the exchange. But buying an index fund is like buying any mutual fund.

Systematic investment plan (SIP) is not allowed in ETFs, while it is allowed in index funds.

Though the expense ratio of ETFs is lower than that of index funds, investors in ETFs pay brokerage costs (on buying and selling) in addition to the expense ratio. Along with these, higher bid-ask spreads in the price due to low liquidity lead to higher total cost of ownership in ETFs.

Normally, other than the expense ratio, there is no such cost included in index funds.

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