Indexing returns

STRATEGIES

Index funds score over actively-managed funds because of lower costs and rising professionalism in the market.

Most experts recommend following a proper asset allocation where some money would be invested in small- , mid- or large-cap stocks. This leads to a proper representation of various industries or sectors of the economy. This was first established way back in 1986 by Brinson, Hood and Beebower: “Approximately 94 per cent of variability of a fund's investment return is due to asset allocation shows a study of 91 large pension funds over a 10-year period.” The study was reconfirmed in 1991.

All these recommendations start with a strategic asset allocation and then do tactical shifts around the same. The major portion of the portfolio, therefore, must be fully diversified. And that core portfolio can be created at a low cost by using index funds.

So far, we had the choice of index funds mirroring large-cap indices – the Sensex and the Nifty. There are some sectoral index funds and also a fund mirroring the Nifty Junior. Many funds are available as open-end funds that can be purchased from mutual fund companies. Some are available as ETFs (exchange-traded funds) that can be purchased through stock exchanges.

The recently-launched Benchmark S&P CNX 500 Fund could be a great option to build a core portfolio at low cost. I would call this fund the Total Stock Market Fund. The fund would attempt to replicate the S&P CNX 500 index, which is a broad index representing almost the entire stock market.

As it invests in stocks of the 500 companies making this index, it has representation across all market capitalisations (companies of large, mid and small sizes), growth and value stocks (the fast-growing companies and the beaten-down stocks), all the sectors of the economy.

In other words, it gives an investor access to the entire Indian economy (at least a large part of the listed universe). This index covers over 90 per cent of the market capitalisation and around 95 per cent of the turnover on the National Stock Exchange. If an investor wishes to participate in the India growth story, this is the ideal option.

Will this fund beat the actively managed funds? Well, this is the most logical next question. However, the question to ask is: “Can active fund management beat the averages at all times?” The statistical evidence may suggest that it is becoming increasingly difficult for active fund managers to beat the market averages.

At the same time, it is even more difficult for advisers and investors to pick up future stars among fund managers. Also, logic suggests that there are certain handicaps with active fund managers that will make it difficult for them to beat the indices. Let us look at some of those handicaps.

The biggest handicap would be costs. We would divide costs between the visible and the hidden. One such visible cost of active fund management is the fund management fees. Generally, the annual cost of index funds is capped at 1.5 per cent. Let us understand this.

According to the guidelines of the Securities and Exchange Board of India (Sebi), active fund management can charge 2.50 per cent a year for the first Rs 100 crore, 2.25 per cent for the next Rs 300 crore, 2 per cent for the next Rs 300 crore and 1.75 per cent for any amount thereafter.

Also, index funds have no entry loads unlike equity diversified funds, which have an entry load of 2.25 per cent. Thus, there is a direct handicap to the extent of the average cost as mentioned above. These are Sebi-recommended upper limits and a fund manager may choose to charge less than this. However, practical experience does not show discounts here.

Over and above the visible annualised costs, there are some hidden costs, for instance, trading commission, securities transaction tax, cash component in the portfolio, bid-ask spread (the difference between the bid price and the offer price for a stock) and impact cost on account of trades by the fund itself.

In the end, let us revisit the question regarding out- or under-performance. Will an index fund generate superior returns over actively-managed funds? The answer is very clear. The index is nothing but an average and an average will always generate average performance.

There will always be some funds that will do better than the index. The problem is that it is almost impossible to identify future winners in advance. Most of the stars of the past turn out to be comets in the future, but averages will always remain averages.

“[Most investors would] be better off in an index fund,” said Peter Lynch.

The author is proprietor, Karmayog Knowledge Academy.