It may be time to allocate some money to index fundsThe passive form of investing has gained significant ground when it comes to developed markets such as the United States. Actively managed funds have seriously struggled in these geographies to beat the corresponding passively managed funds. But is that the case in India? Should the Indian investor look toward index funds as the next thing in their portfolio?

Let’s start with the question of what is an index fund.

Index funds, as the name suggests, invest in an index. These funds purchase all the stocks in the same proportion as in a particular index. This means the scheme will perform in tandem with the index it is tracking, save for a small difference known as the tracking error.

Advantages of index funds

Theoretically, index funds are structured to provide a variety of advantages to investors. The most prominent among them are as follows:

Diversification: Index Funds can provide a variety of diversification based on the following themes:

  1. a)         Asset classes such as equities, and fixed income
  2. b)         Market cap i.e. large, mid and small cap

Low Cost: One of the biggest attractions of index funds has been its low-cost structure, especially in comparison to actively managed mutual funds. The low cost is primarily due to the fact that an index fund is a passive investment i.e. there is no active intervention in stock selection, re-balancing based on a certain view. Therefore the costs associated with hiring professionals and the required infrastructure is avoided, resulting in a significantly cheaper product. Furthermore, most index funds have kept the expense ratios low to induce significant inflows from institutional investors. Following are examples of some commonly known index funds and their respective expense ratios:

INDEX FUND Expense Ratio
UTI Nifty Index Fund 0.20%
Reliance Index Fund – Nifty Plan 0.85%
HDFC Index Fund – Nifty Plan 0.30%
ICICI Prudential Nifty Index Fund 0.92%
SBI Nifty Index Fund 0.67%
Average 0.59%

(Source: Value Research)

Suited to Efficient Markets: it is a global observation that passively managed funds have performed significantly better over actively managed funds where markets are more efficient. This is because, in developed markets, all related information that should be priced into the equity market already happens, leaving very little space for the fund managers to beat their respective benchmark.

Reduced Risks: Due to its passive structure, the risk arising due to stock selections by a fund manager is reduced. Furthermore, as an index fund comprises the same stocks in the same allocation as in the underlying index, tracking error is significantly reduced to the point of it being almost negligible. Tracking Error is the standard deviation between the returns of the fund and the underlying index. A lower tracking error indicates that the index fund will mirror the index more closely and therefore its performance will be more consistent with the same index

Why it did not take off

Despite many advantages that index funds can bring to the table, in India, they have so far been avoided, primarily for the following reasons:

Liquidity: One of the major disadvantages plaguing index funds currently is liquidity.

Lack of awareness: Distributors receive less commission for recommending and executing an investment into an index fund. Because of these low margins, not many efforts have gone into promoting index funds. Thus, most investors are unaware of what an index fund is and how it can add value to their portfolio.

Relative underperformance over the long term: While in theory index funds should outperform actively managed funds in an efficient market, the point to note is that India is still some time away from achieving that status. Hence actively managed equity funds, especially in the top quartile, are able to beat the underlying index and index funds over long-term horizons. This currently results in alpha creation which index funds may take time to match up to.

The following table is a comparison between a random mix of actively managed equity funds and index funds:

 Mutual Fund YTD 3yr
Aditya Birla Sun Life Frontline Equity 31.87 14.03
HDFC Top 200 33.19 11.68
ICICI Pru Focused Blue Chip 34.26 14.19
UTI Nifty Index Fund 29.8 9.71
Reliance Index Fund – Nifty Plan 29.8 9.25
SBI Nifty Index Fund 29.64 9.45

(Source: Morningstar, Date 26th Dec 2017. All data for direct plans.)

As the Indian economy continues its march toward being recognised as a developed nation, there is a fair certainty that index funds will have a far larger role to play. However, in current scenarios, practical hurdles continue to keep them out of favour among investors.

We believe that assigning a small allocation towards index funds — after due diligence, and based on investor’s risk appetite and investment horizon — may be in order. As Indian equity markets evolve, so will the index fund space and this will increase investors’ interest towards them.

Author
Debendra Das

The author is a private wealth manager and financial advisor. The views are his own. Feedback to this article may be sent to contact@rupeeiq.com.