Should You Consider Investing In Index Funds?
Recently, one of the mid-sized fund houses launched four new index funds replicating and tracking different equity indices, including Nifty 500 index and Nifty Smallcap 250 index. These are the first funds in India that are tracking these equity indices. What has led to launch of these index funds?
These index funds are very popular in the developed markets; however, these are yet to capture the imagination of the Indian investors. This is clearly reflected in the latest data of average assets under management (AUMs) under different categories of funds. We see that the large-cap funds still rule the roost and on an average have AUMs of `4091 crore. Compare them with the index funds that have average AUMs of `225 crore and ETFs (after removing CPSE and Bharat ETF) having `1028 crore.
Average AUM of different categories of funds at the end of July 2019
Nevertheless, passive funds (index and ETFs) are growing their stature in the Indian equity market, which is increasingly reflected in their gaining of market share. From the low of 3 per cent at the start of year 2015, the market share of ETFs and index funds has grown to 17% of the total equity mutual funds at the start of January 2019.
There are different reasons why index funds are gaining traction. Besides the larger interest by the institutional investors such as the EPFO, one of the basic reasons passive investments is gaining ground is their low cost. If we check the expense ratio of open-ended equity fund at the end of July 2019, index funds are far cheaper than actively managed funds.
The table clearly shows that the index funds and ETFs are cheaper and cost one-third of the cost of other actively managed regular funds. Although the difference looks quite low (around 1.5%), in the long run, it has a huge impact on returns. For example, this meagre difference will compound to about 6% in 3 years, 13.5% in 5 year and a huge 56% over 10 years.
Another reason why index funds are popular is their high survival rate, which means the number of index funds that lasted for longer period is high. According to a report by S&P Index vs Active studies, only 67% of the actively managed large-cap and mid/small-cap funds survive for 10 years ending December 2018. The rest were mostly merged with better performing funds to hide their inferior returns. In case of index funds, their chances of survival are high as they track indices and performance is linked to the indices that they track.
What is an index fund?
An index fund is a mutual fund scheme that endeavours to track and replicate the constituents of its target benchmark index
☛An index fund aims to maintain a portfolio of investments that is weighted in the same proportion as its benchmark index in order to mirror its performance.
☛The expense ratio of index funds is generally lower than actively managed equity funds
☛There is no active selection of stocks by the fund manager
☛The portfolio is rebalanced periodically only when companies enter/exit the index
Benefits of investing in index funds
Index funds are an easy and convenient way to invest in an index
☛Eliminates fund manager risk and, therefore, the risk of underperforming the benchmark
☛Diversification–Generally tracks broad-based indices, thus reducing the impact of decline in value of any one stock, industry or sector
☛Low costs –Since index funds are passively managed, costs are relatively low
☛Transparency –As indices are pre-defined, investors know the sector, companies and proportion in which their money will be invested
Difference in returns
The biggest differentiator between active funds and index fund is their returns. It has been observed, both domestically and internationally, that in the long run, index funds have outperformed their benchmark indices.
Source: S&P Dow Jones Indices LLC, Morningstar, and Association of Mutual Funds in India. Data as of Dec. 31, 2018.
The graph shows the percentage of funds that have outperformed their benchmark indices. We see that in the case of large-cap (comparison index S&P BSE 100) and ELSS (comparison index S&P BSE 200) in one year period, these have severely underperformed their comparison index. Less than 10% of the large-cap and ELSS funds were able to beat the performance of their benchmark index. Nonetheless, in the case of mid-cap and small-cap dedicated funds, almost three-fourth of the funds have been able to beat their benchmark index in a one year period.
If we take a longer period of investment, say 10 years, most of the funds have underperformed their indices. The only change is that large-cap funds have improved their performance, while mid-cap and small-cap funds have witnessed moderation in their performance.
The above study coincides with one of the best bull markets (2009-2019), which shows that even in the best of the years, funds have not been able to beat the indices. Moreover, in the year 2010, if you had invested in the top performing 50 active fund based on 5-year performance, 5 are still in the top 50 as of Dec 31, 2018, and only four have outperformed the index.
Should You Go For Index Funds?
A deeper analysis of the index funds and the respective actively managed fund shows that large-cap funds fail to beat their benchmark indices consistently. There may be some funds in some years that might outperform the index, however, it has been a bit difficult to maintain their performance on a consistent basis. The reason being large-cap companies are well-researched and hence unable to generate alpha. Even if actively managed funds continue to perform just like the market, their expenses will continue to drag their returns. Therefore, a long term investor should include large-cap dedicated index funds instead of an actively managed fund in his portfolio.
In the case of mid-caps and small-caps, you can go for actively managed funds instead of passively managed funds. The reason being in an emerging economy like India, where there are still a huge number of under-researched stocks beyond top 100, the fund managers get to pick better stocks that help them to outperform their benchmarks.