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Moving with the Market

Moving with the Market

For the first-time equity investor, index funds are a relatively safer option as they take the guesswork out of investing. Besides, the charges are lower.

How are your equity funds performing? Considering that the Sensex has dropped almost 6% in the past 12 months, the returns can’t be awe inspiring. They have, however, been very volatile. If you had invested in Reliance Regular Savings Equity (best performing diversified fund) , it would have earned you 14.6% returns in the past year. But if you had chosen the JM Hi Fi (worst performer) , you would have lost 30.86%.

There are several reasons for this wide variation, but ultimately it all depends on the skills of the fund manager. Does he have the expertise to pick out multi-baggers? Can he foresee a downturn and contain the risk? The bigger question is, are you comfortable with betting on the stock-picking ability of one individual?

This is where the index funds come in. They invest only in the stocks that are present in their benchmark index and in the same proportion as their weightage. For instance, Bhel has a 3.17% weightage in the 50-share Nifty. So, any index fund benchmarked to the Nifty will have 3.17% of its corpus invested in Bhel. As a result, the fund will closely track the movement of the index because it has only those 50 Nifty stocks. “Index funds are good for investors who want to gain equity exposure through an index,” says Yogesh Bhatt, vice-president (investments), ICICI Prudential AMC .

Index funds have given annualised returns of 25% in the past five years compared with the 31% delivered by diversified equity funds. But lower returns also mean lower risks. A look at the yearly returns from index and diversified equity funds since 2003 shows that while diversified funds shot up quickly during the bull run in 2004 and 2005 (see graphic), they fell equally hard when the correction came. In contrast, index funds rose at a slower pace when the markets were rising, but have not lost as much as the actively managed funds during the downtrend. It’s a perfect prescription for someone who wants to invest in equities but is not comfortable with entrusting his money to the whims of one fund manager or to a specific sector. It’s for those who want to move with the market.

There’s another good reason for investing in index funds. They don’t charge as much as the actively managed funds. Diversified funds have an army of equity analysts and researchers, who put every stock under a microscope before it is bought by the fund. For all this, the fund charges an investor 2-2.5% a year as expense ratio. That’s Rs 2,000-2,500 shaved off every year from an investment of Rs 1 lakh. Nobody grudged this 2-2.5% to mutual funds when the returns were in the range of 30-40% a year. But now, when the returns are in the red, this expense ratio adds to the losses.

Top five index funds
FundExpense Ratio (%)NAV (Rs)1-year returns3-year returns
ICICI Pru Index Fund-Nifty Plan1.2540.640.9124.71
Nifty BeES0.50452.01-0.2923.56
UTI-Master Index Fund0.7546.70-3.9223.44
Tata Index Fund-Nifty Plan (A)1.5026.94-2.5823.30
Franklin Index Fund-Sensex Plan1.0042.00-2.3523.08
Nifty  -0.7022.50
Sensex  -3.6623.48
Data as on 5 Sept 2008
Source: NAV India

Managing an index fund doesn’t require too much effort. There’s no need for research and the portfolio is churned only if an index changes. This means lower transaction costs and fewer expenses, making index funds cheaper than the actively managed funds. The expense ratio of index funds ranges from 0.5% to 1.5% compared with up to 2.5% in diversified funds. “This difference can balloon over the years and becomes a significant portion of your return in times of moderate returns,” says Sanjiv Shah, executive director, Benchmark AMC .

Another point to note is the benchmark-adjusted return. The actively managed equity diversified funds display a far higher deviation from their benchmark indices. We compared the returns of the top 50 diversified equity funds and their benchmarks over the past three years and over five years (see graphic). In the long term, diversified equity funds tend to outperform their benchmarks by a wider margin. However, Shah feels that with massive corpuses, diversified funds may find it difficult to outperform the index funds consistently.

In index funds, the deviation from the returns of the benchmark can be due to several factors— expenses incurred by the scheme, not being completely invested when markets rise, investments in derivatives and delay in changing the portfolio in line with the index.

The lower the tracking error, the better it is. “One must shortlist index funds on the basis of the tracking error before considering other factors like loads,” says R. Swaminathan, vice-president, IDBI Capital Market Services. The average tracking error for index funds in the past year has been 1.89% (see table). The global average is 0.13%.

If the tracking error rises above these levels, it is cause for concern. That’s because it implies that the fund is not sticking to its mandate of mirroring the index. It may be taking on more risk than the investor is comfortable with.

For instance, the LICMF Index Fund (Sensex plan) has had a tracking error of over 9.38% in the past three months. This deviation is evident in the fund’s performance as well. While the index has lost 3.9%, the fund has lost over 9% in the past three months. Besides costs (expense ratio of 1.5%) and cash levels in the fund, the deviation in returns was also due to the difference in weightage of some stocks. For instance, the fund’s allocation to Reliance Industries was 15.5% on July 31 compared with the scrip’s 12.2% weightage in the Sensex.

One major drawback of the index funds is that the investment universe is limited. Most of the index funds track either the Sensex or the Nifty, thereby confining themselves to just 55% of the total market capitalisation. Sure, some ETFs track sectoral indices but a large chunk of stocks are left out.

“To address this issue we are planning a fund that tracks the SNP CNX 500, which will offer a broader investment universe,” says Shah. But not all indices give equal returns. A wider choice would require investors to pick an index that suits their investment objectives and risk profile.