Mutual Funds

Why you should invest in index funds

Dhuraivel Gunasekaran BL Research Bureau | Updated on October 16, 2019 Published on October 16, 2019

Index funds can be a better bet for investors   -  istock/RomoloTavani

Active large-cap funds have underperformed their benchmarks over the long term

Index funds have been gaining popularity in recent times thanks to the underperformance of the actively managed large-cap funds against their benchmarks. The underperformance is now visible in ten-, twelve- and fifteen-year time-frames also, though marginally.

Data shows that the regular plans of actively managed large-cap funds delivered 7.3 per cent and 14.3 per cent compound annualised returns in twelve- and fifteen-year periods, respectively, while the Nifty 50 TRI posted 7.6 per cent and 14.5 per cent returns, respectively. The other large-cap benchmark, Nifty 100, TRI clocked 8 per cent and 14.9 per cent returns, respectively (see graph).

Large-cap funds are actively managed equity funds investing at least 80 per cent of their assets in the top 100 listed stocks by market capitalisation. They aim to perform better than benchmark due to active management of the portfolio.

On the other hand, index funds are passively managed mutual funds that try to replicate the performance of the underlying benchmark. They imitate the portfolio of an index (say Nifty 50) by investing in stocks that are a part of the Index in the same proportion as in the index. The other variant, Exchange traded funds (ETFs) are also passively managed mutual funds traded on the BSE and the NSE. Investors need demat and broker accounts to buy and sell the ETF units.

Since the actively managed large-cap funds have underperformed their large-cap indices, many financial advisors are suggesting index funds tracking Nifty 50, Sensex and BSE 100 indices to investors instead of large-cap funds.

Why the underperformance

The move towards TRI-based (Total Return Index) benchmarking in the early 2018, is one of the reasons for this under-performance of the actively managed funds. Normally, TRI returns are about around 1.5 percentage points higher than normal index returns.

The expenses charged by actively managed funds are around 1.7-2.8 per cent, which is higher compared to 0.2-1.2 per cent charged by the passively managed funds.The higher expense ratio eats into the returns in the active funds.

The SEBI’s reclassification norms have standardised the allocations in the large-cap funds. Earlier, significant portion in the actively managed large-cap funds was invested in mid and small cap stocks that spiced-up extra returns. With their hands tied, returns of large-cap funds are declining.

Over the last two years, the returns from Sensex and Nifty were mainly from a handful of stocks. The active large-cap funds which had lower or nil exposure to these stocks lost out as they need to hold a diversified portfolio.

Index funds in India are largely dominated by the institutional players. Flows in to these funds improved after the EPFO and pension funds were allowed to invest in them. The government’ divestment plan through ETF route also brought in more flows.

 

The kitty

Index funds can be a preferred option for investors wanting index linked returns. Investors new to equity market can also consider opting the index funds route.

Currently, there are 32 index funds available in the market. You have a wide choice of index funds based on the broader indices, including Nifty 50 (15 funds), Sensex (5), Nifty Next 50 (4), Nifty 100 Equal Weighted index (2). Banking sector, mid-cap, small-cap and Nifty 500 index funds are also part of offering.

Apart from the returns, the efficacy of index funds is measured through the Tracking Error (TE), which measures how closely an index fund tracks its chosen index. In simple language, TE is the difference in returns between an index fund and its benchmark. Index funds with lower TE are preferred choices.

Under the index funds tracking Nifty 50 index, the index funds with lower TE are SBI Nifty Index, Franklin India Index Fund-NSE Nifty and IDFC Nifty Fund. Under Sensex index funds, HDFC Index Fund-Sensex and Tata Index Fund-Sensex Plan have closely tracked their benchmark. IDBI Nifty Junior Index and ICICI Pru Nifty Next 50 Index Fund are the preferred index funds that track Nifty Next 50 index.

Index funds versus ETFs

Index funds score over the ETFs on various counts. First, liquidity has been a major issue when trading in ETFs. But index funds are directly bought and sold from the AMC hence liquidity 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. Investors in ETF’s pay brokerage costs (on buying and selling) in addition to the expense ratio which lead to higher total cost of ownership in ETFs. Normally, there is no such cost included in the index funds other than expense ratio.

Systematic Investment Plan (SIP) is not allowed in ETFs. SIP is allowed in index funds.

Published on October 16, 2019
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