Investors have two strategies that they can adopt to grow their wealth – active and passive. While active strategies have been well highlighted, passive strategies, like their name, have remained in the background for quite some time.
But in recent times, this has begun to change.
Passive strategies have gathered some limelight and gained traction among financial market practitioners and investors. The instruments which help investors deploy these strategies are index funds and exchange traded funds. Their counterparts pursuing active strategies are mutual funds.
While index funds are a type of mutual fund, they are different in the manner that mutual funds employ the services of a fund manager and a supporting research team. They help in stock selection which shapes the construction of the portfolio. They do this with the aim of outperforming the benchmark of the fund. On the other hand, index funds simply track an index. This means that they invest in the same stocks in the same proportion that constitute their underlying index. The implication of this is that index funds just match the returns of the market with no intention of outperforming it.
It is important to note that the returns of an index fund will always be slightly lower than its benchmark. This is represented by tracking error. The higher the tracking error, the lower the returns of an index fund compared to its benchmark.
Since they employ the services of investment professionals with the aim of beating the market, mutual funds tend to be more expensive than index funds. For instance, while typical equity oriented mutual funds can charge an expense ratio of up to 2.25%, the same for an index fund is capped at 1%. In practice, several large cap equity funds charge 1% to 2% as expenses while index funds may end up charging less than 0.5%.
Among index funds and ETFs, investors can choose different indices to replicate. There are funds which mimic broad based stock market indices like the S&P BSE Sensex and the Nifty 50. By doing so, one can make the top 30 or 50 stocks by market cap a part of their investment portfolio. Along with this, the cost associated with investing in such funds is on the lower side because of the large asset base of such funds.
Apart from headline equity indices, investors can also invest in funds which mirror indices like the Nifty Next 50 which is comprised of 50 stocks by market capitalization beyond the top 50 which form the Nifty 50. Investors can also invest in sectoral funds which track funds from various sectors like banking, technology, consumer, pharmaceutical, etc. ETFs tracking large PSUs like Bharat 22 ETF and the CPSE Index ETF also are interesting options for investors.
These options have opened up for investors as there has been high demand for index funds. Let’s look at the top 5 reasons why index funds have witnessed booming demand in India:
Active Management Leaves a Lot to be Desired
As we have seen earlier in the article, actively managed funds are more expensive than their passive peers because they employ the services of fund managers and analysts who are tasked with the responsibility of beating market returns. But several studies across countries have shown that only few active funds are actually able to achieve that objective. This does not mean that active fund managers never outperform market indices; it just implies that doing so consistently year after year is extremely difficult.
The SPIVA report checks for fund performance vis-à-vis its benchmark. According to its report which studied data for Indian large-cap funds up until December 31, 2018, 92% of such funds under performed their benchmarks in the past one year. This pattern seems consistent even over longer time periods; over a ten year span, over 64% of the funds under performed their benchmarks.
Because of this, the investor community has to think whether it is worth paying more for services which are not yielding the desired results. It may be better to invest in an index fund which will at least mimic market returns for certain (minus the tracking error) rather than paying more for an active fund which may beat the market a few times but not consistently. And even when it does, paying the high fee for it may not be worth it.
Outperforming Has Become Harder
In the past few years, it has become more difficult for fund managers to beat market returns because of some changes. For example, the performance of funds is now benchmarked to the total return index (TRI), while earlier it was only price returns that formed the benchmark. It is more difficult to beat a TRI as it includes dividends as well apart from capital gains.
Further, the Securities and Exchange Board of India (SEBI) has recategorized mutual funds. This has resulted into a narrower band within which fund managers can constitute their portfolio. This curtails some of their freedom in portfolio construction and thus hinders their ability to outperform the market.
Index Funds Typically Carry Lower Risk
Though active funds have the flexibility to change the portfolio composition as and when the fund management team feels, this also means a higher portfolio turnover which increases fund management and administrative costs.
Apart from increases costs, it also means an increase in the risk assumed in order to outperform the market. On the other hand, since index funds just replicate their benchmark, their risk tends to be typically lower than their active peers of the same fund category.
Index fund investors are assured of similar returns to their benchmark. Though no one can predict the performance of any equity index, one can be aware of the performance of their index funds based on the performance of the underlying index. However, for active fund, this is not the case, making the unpredictability factor higher than that for index funds.
Awareness About Portfolio Composition
Since index funds just mimic a benchmark, investors can know where their money is invested just by looking at the benchmark on a daily basis. While active funds also disclose their portfolios, they do so on a monthly basis which is not indicative of portfolio changes that were made during a month.