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Why choose index funds

Why choose index funds

Why pay a high fee and try to outperform the index when tracking it is much cheaper?

Dipen Sheth

Tonnes have been written about how best to pick a mutual fund. But finally, what matters is how well you judge the risk-reward deal that you are entering into. Upsides are easily ‘bought into’, but a clear understanding of the downsides is essential. Apart from the inherent risk in equities, you must prepare to bear the fund management fees. Typically, this ranges from 1-2% of the average assets under management. Along with other costs, such as brokerage and custodianship, you end up paying about three rupees for every hundred that you commit to the fund manager.

Why should you pay such a high charge when an index fund is available for an under 1% annual fee? Why become greedy and try to outperform the index when tracking it is considerably cheaper? Passive investing is a gift for the masses who want a fair slice of their wealth in the stock market and are willing to settle for index returns over time—for very low fees.

Mutual fund performance is not so much about stock selection (check some leading open-ended mutual fund portfolios to see how similar they are) as it is about taking a broad view of the markets and choosing to invest or remain in cash. This is one of the biggest dilemmas for a fund manager: how much cash to hold? Most of them have gotten around this question by staying almost fully invested; they are obsessed with short-term performance relative to their benchmark index. They claim that the cash call must be taken by investors.

This is a serious abdication of the ‘absolute return’ responsibility. You don’t pay nearly 3% fees to lose money with the index; you should demand that your fund manager figure out the declines well in advance and move your money out of the market, or buy stocks much before sustained rallies. But the people who charge more than the index fund in return for the promise of index outperformance hide behind ‘relative outperformance’ when the market falls, by saying things like ‘we lost 20% while the index fell 35%’.

Surely a system that pays the same fees to the fund manager, irrespective of performance, is unfair? Why fret over beating the index and running the risk of under-performance but pay high fees? If you are a longterm investor, you can be happy with index-linked returns. In that case, index funds should attract the maximum inflows. But this is not true, at least in India. It’s the greed for higher-than-market returns that makes ‘actively’ managed funds prosper.

This greed to beat the index is not bad. You agree to a higher fee compared with an index fund in exchange for better performance. Logically, investors should have the right to withhold some of this fee if the promised outperformance does not happen. But they don’t; there isn’t one mutual fund that offers very low management fee if a base performance is not met.

Sadly, mutual funds are a grossly mis-sold, mis-positioned and miscommunicated financial product in India. In spite of the terrific growth of the mutual fund industry, it’s value is still just about Rs 6 lakh crore in the overall lifetime AUM. That’s under eight months of the national household savings. Clearly, there’s an opportunity in this messy situation. And the fund house that has the guts to offer rock-bottom management fees (when they underperform) will get the prize.

Dipen Sheth is Vice-President, Institutional Equities, BRICS Securities Ltd.

Published on: Jun 12, 2009, 10:58 AM IST
Posted by: AtMigration, Jun 12, 2009, 10:58 AM IST