Download the latest issue of Business Today Magazine just for Rs.49

Smart Investing

Low-cost index funds are emerging as top picks as they stand the test of time in outperformance

Illustration by Raj Verma Illustration by Raj Verma

Ever wondered which is the world's largest mutual fund scheme? You will be surprised to know it is an index fund in an industry that swears by active funds. Launched by John Bogle in 1976, First Index Investment (now Vanguard 500 Index Fund) had only $1 billion in assets under management (AUM) till 1990. It now has an AUM of over $700 billion.

Index funds (also called passive funds) invest in stocks that comprise an index such as the Nifty50, the Bank Nifty, etc. These are cheaper than active MFs that rely on stock-picking by fund managers.

Of the top 10 funds in the US, nine are passively managed index funds. According to boutique portfolio management service firm QED Capital, PMS in the last 10 years in the US, active mutual funds saw an outflow of $1.2 trillion and index funds/ETFs an inflow of $1.4 trillion. As on March 2021, the US MF industry had $14.25 trillion worth of active assets and $10.62 trillion of passive assets. Passive equity assets had surpassed active equity assets briefly in 2019.

The India Story

India's 'passive' revolution has just started, but is catching up fast. From Rs 9,952.01 crore in April 2020 to Rs 20,426.01 in April 2021, the AUM in index funds has more than doubled. There has been a growth of 1,029 per cent from Rs 1,808.69 crore in April 2016. A large part of it is due to the EPF money that has flown into index funds after 2015 (the government allowed 15 per cent of incremental EPF corpus to be invested in index funds since they are considered relatively safe).

The contribution of index funds to the overall mutual fund industry AUM, however, is still in single digits. It has grown from around 1 per cent in 2016 to 9 per cent over the last five years, data from Morningstar show.

The MF industry seems to have read the writing on the wall. As many as 17 index funds and ETFs were launched in 2020. This year has already seen 15 launches, according to Morningstar data. In fact, Motilal Oswal launched India's first international passive fund in 2020, which tracks the US S&P 500 Index. It had already launched an international ETF, Nasdaq 100 ETF, in 2011. "Among 14 index funds and ETFs that we have now, the international ones are the most popular. As much as 70-75 per cent of AUM is concentrated in the S&P 500 Index fund and the Nasdaq 100 ETF, which happened in a matter of two years," says Pratik Oswal, Head, Passive Funds, Motilal Oswal Mutual Fund.

Active Versus Passive

Data from QED Capital, PMS show actively managed equity mutual funds have given 9.17 per cent time weighted rate of return (TWRR) - the measure of the compound rate of growth in a portfolio - in the last 20 years, against 13.99 per cent on the Nifty BeeS, an ETF tracking the Nifty. The Nifty50 TRI (Total Returns Index), which includes dividends, gained as much as 15.21 per cent during the same period.

"We have included large-caps, midcaps, small-caps and all combinations to get a clearer picture. Secondly, we calculated TWRR, which eliminates the impact of fund inflows and outflows from return calculation because it is not under the control of the fund manager," says Anish Teli, Managing Partner and Principal Officer, QED Capital, PMS .

In the last six months of 2020, 100 per cent of the actively managed large-cap equity funds underperformed the S&P BSE 100, shows the SPIVA (S&P Indices Versus Active) Scorecard, a semi-annual study on active and passive funds. The report suggests that 68.42 per cent of large-cap funds underperformed (or, only 31.58 per cent outperformed) the benchmark index over the 10-year period to December 2020. Moreover, large-cap funds witnessed a low survivorship rate of 70.68 per cent during the same period. It means the rest of the funds might have liquidated or merged during the period of study, according to the SPIVA report.

Cost Is Key

What works in favour of index funds is simplicity and low-cost. Invest and forget - that's the mantra. Underperforming stocks are excluded from the index and the good ones are added. Also, the expense ratio on index funds is much lower than that on active funds. Total expense ratio (TER) is a percentage of one's investment that AMCs charge as a fee for managing funds. Simply put, if you invest Rs 5,000 in a fund which has an expense ratio of 2 per cent, you pay Rs 100 as the TER. So, if a fund gives a 15 per cent return and has an expense ratio of 2 per cent, you would earn 13 per cent.

The TER on active funds is 1-2.25 per cent. It could be as low as 0.2 per cent for most index funds.

Morningstar estimates the weighted average median TER in per cent for equity funds at around 1.93 per cent. So, if the AUM of equity oriented MF schemes is around Rs 10.88 lakh crore as on May 2021, over Rs 21,000 crore would have been paid by investors as TER.

According to QED Capital, PMS data, the MF Industry has underperformed the Nifty BeeS by 4.8 per cent, up from 2.2 per cent in 2019. "The 2-2.5 per cent difference can be explained by what the industry charges as expense ratio... In fact, the greater the expense ratio of a mutual fund, the higher is the underperformance," says Teli, whose firm offers a mix of active and passive products.

Investing In SIPs

How does expense ratio impact your SIP investment? If you start an SIP of Rs 5,000 in an active fund you may have to go to a distributor since you wouldn't know which mutual fund to buy. "Investors might end up paying an expense ratio of 1.5 per cent or more. But, if they decide to buy a Nifty Index fund, they don't need a distributor since they can buy a direct plan of any Nifty Index fund, which has a low expense ratio and higher AUM. These expense ratios can be as low as 0.2 per cent per annum (or even lower in some Nifty ETFs). So, the savings every year could be 1.3 per cent or more," says Varun Malhotra, Director and Founder, Edge Institute of Financial Studies.

Assuming a monthly SIP of Rs 5,000 for 10 years at 15 per cent per annum in an index fund, you accumulate around Rs 13.76 lakh. If you invest the same amount in an active fund, you would earn 1.3 per cent less. At 13.7 per cent per annum, you would accumulate Rs 12.72 lakh. There will be a loss of Rs 1.04 lakh due to the higher expense ratio.

"As the number of years increase, savings go up significantly. A SIP of Rs 5,000 for 40 years at 13.7 per cent per annum would result in a corpus of around Rs 10.13 crore. But a SIP of Rs 5,000 for 40 years at 15 per cent per annum would mean accumulating Rs 15.5 crore," says Malhotra.

Road Ahead For Active Funds

Active investment is based on the acumen of fund managers and advisers tracking down potential outperforming funds. In his book Thinking, Fast and Slow, Israeli psychologist and economist Daniel Kahneman says once he was granted a 'small treasure' of the investment outcomes of 25 anonymous wealth advisers for eight years. When he computed the year-on-year correlation between the outcomes of MFs, it was barely higher than zero. "The successful funds in any given year are mostly lucky; they have a good roll of the dice. There is general agreement among researchers that nearly all stock pickers, whether they know it or not - and few of them do - are playing a game of chance," he wrote.

One area that still holds relevance in active management is the mid- and small-cap space. Fund managers are better placed at spotting hidden gems much before they join the benchmark mid or small-cap index. The SPIVA Scorecard shows 53.06 per cent of mid- and small-cap funds outperformed the benchmark S&P BSE 400 MidSmallCap Index in the second half of 2020. The category fared the best, with the majority of them managing to beat the S&P BSE 400 MidSmallCap Index over the 10-year period to December 2020.

"Investors have compared passive and active investments from a performance perspective. But it's important to understand that both active and passive funds can complement each other in one's portfolio. Rather than looking at which one outperforms, it's important to look at the basics - an investor's risk appetite and long-term goals," says Kavitha Krishnan, Senior Analyst and Manager, Research, Morningstar India.

So far as ultra-high networth (UHNIs) are concerned, they now prefer PMS and Alternative Investment Funds (AIFs) over mutual funds for the much-coveted alpha (the excess return over a relative benchmark index). "In the US, a lot of active fund managers left the MF industry and joined AIFs and PMS because those segments give you flexibility in what to buy and sell across asset classes. Gradually, India is moving towards that direction, but obviously only HNIs and UHNIs can invest in PMS and AIFs due to the cap on minimum investment. Taking the SIP route in index funds is the best for retail investors," says Oswal.

So, is it dumb to mimic the index? "When 'dumb money' acknowledges its limitations, it ceases to be dumb, Warren Buffett once said. In fact, he wants 90 per cent of his inheritance to be invested in the Vanguard 500 Index Fund for his wife after he is gone. Choose simplicity over chasing alpha. The dumb is turning out to be the new smart.


Published on: Jun 24, 2021, 10:23 AM IST
Posted by: Vivek Dubey, Jun 24, 2021, 10:23 AM IST