Should you invest in index funds like Warren Buffett?

Only if you are a conservative investor satisfied with index returns; but over long term actively managed funds give better returns in Indian markets

At Berkshire Hathaway’s Annual General Meeting last week, Warren Buffett said that investors can make good returns by investing in index funds, which are passive funds. Citing the example of Vanguard Group index fund that tracks the S&P 500 index of large American companies, Buffett said that passive, unmanaged or ‘no energy’ investments can do just as well, or better, than ‘hyperactive’ investments handled by consultants and managers who charge high fees.

Does this principle of making good returns from passive index funds or Exchange Traded Funds hold good in the Indian markets too? Can Indian investors too follow this investment philosophy of Buffett?

Not entirely, says according to Vidya Bala, Head of Mutual Fund Research at FundsIndia.com. The big difference is that in the USA most indices are available to investors. But India is still more of an emerging equity market, where new companies are still being discovered and are yet to be listed or become part of the index.

“We do not have dynamically managed indices or innovative indices. While there may be indices within the stock exchanges, these are not available for investing. Because we have so much scope of investing outside of indices, investors are able to make money by investing in actively managed funds,’’ she says.

Kaustubh Belapurkar, Director - Fund Research, Morningstar India agrees that index funds are more relevant for the US markets than India.

“In Indian market any fund manager provides lot of alpha over the index. In case of actively traded large-cap funds, the returns could be higher than the index by 200-300 basis points over a five year period. While in case of mid-cap funds the returns could be even more higher. That is why over the long-term actively adjusted funds will give better returns,’’ he says.

The biggest advantage of index funds is the low cost. The expense ratio of most index funds is less than 1%. In case of Exchange Traded Funds the expense ratio is lower than 50 basis points. As against this in case of active funds the expense ratio is around 1% in case of direct funds and can be above 2%. But as both Belapurkar and Bala point out, returns for actively managed funds are already adjusted for the expense ratio and justify the higher charges.

Another advantage of index funds is the low volatility. While active funds may give higher returns, they can also be extremely volatile. For instance, an active fund may give 5-10% higher returns, but returns could also fall by the same margin. That is why index funds are suitable for those investors who wish to avoid volatility in their investments, say a fund manager.

“In the longer run active funds do give higher return because of the exposure to mid-cap stocks and mix of stocks. However, investors in index funds can enhance their returns by investing more when the indices are trading lower, say 11 or 12 Price/Earning ratio and exit when the indices gain," the fund manager adds.
 

According to data from Value Research, five-year returns from the top five large cap equity funds have over a five-year period have been in the range of 8.18 to 12.26%. While the returns for index funds have been in the range of 6.37 to 7.16%.

Another factor to watch out for is the tracking error, which is a measure of how closely the fund follows the index which it is benchmarked to. In index funds, tracking error can be bother higher and lower than the index.

“Ideally, the tracking error should be one where returns are higher than the index. Why should investors invest in anything that compromises the returns? Occasionally, returns can be lower than the index by 10-20 basis points, in some quarters. But a good fund manager should always ensure that tracking error is minimal," says Bala.