The Mistaken Allure of Index Funds

Index funds are the norm and the “thing” in the US for quite some time now. They are  considered the best and easiest form of investment.

But fortunately or unfortunately India is a different ball game all together. This means that the much loved index funds are not the best investment strategy for Indians, at least for the foreseeable future. Let’s understand why.

What are Index Funds?

Index Funds are a passive form of investing. Index fund’s main objective is to generate return in-line with its benchmark. They are basically a no-brainer fund, as they just mimic the benchmark portfolio.

For example, a fund tracking the Nifty 50 Index will buy the same 50 stocks and in the same proportion as represented in the Nifty Index. Also, in case of any changes like replacement of one stock with another in Nifty 50, the index fund will undergo the same changes.

This is in direct contrast to actively managed funds. In an actively managed fund the main objective is to beat the market or benchmark returns. The fund manager has complete leeway as to how he or she wants to construct their portfolio, in order to generate higher returns.

Allure of Index Funds

The main attraction point of Index Funds in markets like the US are:

  • Low cost
    As Index funds do not require active research and stock picking, the expense cost of these funds are comparatively lower than that of actively managed funds.
  • Ready-made diversified portfolio
    Since one is mimicking the index itself, one is getting a ready-made easy portfolio without much effort. Also, since the index is a representative of entire market the said portfolio will be well diversified also.
  • Better Returns
    The fund managers of active funds are not able to beat the benchmark consistently in a well-oiled market like the US. Therefore, Index Funds are seen as the perfect solution, since they provide benchmark returns at low cost.

While the above mentioned advantages may hold true in case of developed market like the US, in India this is not the case. Here is why:

  • Index in India does not represent market correctly
    The main argument held in favour of index funds is that they own all the securities in an index, which is fair and representative sample of the market. But this is not true in case of India.
    Sensex may be the barometer of market, but it cannot be considered a guideline for investing. This is because it’s certainly not diversified enough to capture all the sectors. Sectors like textiles, aviation etc. find no place in it.
    Similarly in Nifty – shipping, consumer durables, agriculture etc. are missing. Even if the sector is represented in the sensex, the selection of stocks are not usually  the best.
    For example, PSU Banks is represented by SBI only, but stocks of Syndicate Bank and Vijaya Bank are performing much much better than SBI Bank in terms of returns.
    The main reason for this is that Index stocks picked in India have liquidity as a major consideration. Only companies having the highest market capitalization or liquidity find a place in these indices and therefore some great performing and sound companies get left out. A stock may find its way to the Sensex or Nifty, but that doesn’t mean it is the best buy in its field. Smaller companies may provide better investment options.
  • Active Funds have outperformed Index Funds regularly
    Many actively managed diversified funds have beaten the index funds over time in Indian market. This is due to the fact that India is an emerging market, where new companies are still being discovered and are yet to become a part of index. Since we have so much scope of investing outside of indices, investors are able to make more money by investing in actively managed fund. The average rupee invested in an equity mutual fund continues to grow faster than the index fund.

    Unlike index funds a computer algorithm is not deciding where your money goes in a managed mutual fund but an actual real person called the fund manager is taking those decisions using all his skills, experience, wisdom & research to figure out where to steer the ship.

  • Low cost not such a big attraction
    After the introduction of direct funds the difference between the cost of index fund and actively managed fund is not that high. Currently, the expense ratio of index fund is less than 1%, as against the regular funds where cost can be above 2% or direct funds where expense ratio is around 1%. Although no doubt, active funds are costlier, but this extra cost gets justified by higher returns. Returns for actively managed funds are already adjusted for the expense ratio, and are still higher than index funds.

Index Funds are not going to gain popularity in India as long as there is a lack of dynamically managed or innovative indices. Till then, actively managed funds will continue to outperform & will be preferred over index funds.

Therefore, don’t just start investing in Index funds in India after reading about them on the internet, and even if you want to invest in them, allocate a small portion of your investment to index funds and invest the rest in a better performing actively managed fund.

After all it’s about earning more returns, right?

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