Index Funds - A Way to Go?

In this week's FinMail we are going to discuss the most common solution to the Investor's Dilemma - Which Mutual Fund should I invest in? We look at how are the opinions of some Financially Aware Influencers might be wrong.

The Context:

Recent Data from AMFI showed that the number of folios in index funds doubled from ₹4.05 lakh to ₹8.11 lakh in the last 13 months. During the same period, assets under management (AUM) of index funds surged 95% to ₹14,794 crore.

Passive Funds - especially Index Funds have been gaining popularity lately and people have been shifting from Active Mutual Funds to Passive Mutual Funds for one reason - Active Mutual Funds are costlier and it decreases the amount that you could have accumulated if the Expense Ratio was lesser.

Index Funds are gaining traction for some time now, as preached by authors of some well-known finance books and advocated by none other than Warren Buffet. Every other social media page/account with the niche of Personal Finance suggests Index Funds as a way to go for long term investment.

So let's jump right into the discussion but first let us understand what are index funds.

Simplifying Index Funds -ft. Chess

Let us take an example of the game of chess to simply understand Index Funds. Let's say you have been challenged to an online game of chess by your friend. The winner gets free drinks from the loser. You accepted the bet in the spark of the moment but soon realised that you are not an expert in chess. So you call your other friend, who is a master at the game of chess to seek help. Your friend suggests you a trick which goes like this.

You will play as a black player against your friend. Meanwhile, on the backside, you will start another game with a bot or a computer in which you will playing as a white player and the bot as a black player. What your Chessmaster friend asked you to do is to play a 'mirror game on the backend'.

So what you will do is when your opponent friend plays his move in the online game, you will mimic his moves as a white player in the backend game. So when your friend moves his soldier two steps forward, you will also move your soldier two steps forward in the backend game against the bot. When the bot makes a move against your move, you will mimic the moves of the bot in the online game against your friend. So you will take a help of a bot who will be your benchmark to plan your moves and mimic exactly what it does to strengthen your game.

In the same way, Index funds also follow the same strategy. It chooses an Index as a benchmark and it follows the Index's Investment Strategy. So for example, if an Index fund has a benchmark of Nifty50, it will follow everything that the Nifty50 does. The fund will have the same composition as Nifty50, the fund will have the same stocks as the Nifty50 and also the fund will have the same weight of a particular stock that the Nifty50 has. So for example, if Reliance's weight in Nifty50 is 11%, the index fund will also have 11% of its funds invested in Reliance's stock. This is done to match the fund's return with that of the benchmark and having the same risk as that of the benchmark.

But Why Index Funds are gaining traction?

Index Funds are becoming popular because of the market crash in April-May due to which many Mutual Fund investors faced losses and active funds being costlier were the center of the heat. And then some experts, as well as some influencers on social media pages, started praising Index Funds because they are cheap in cost and provide returns that are closer to the benchmark returns. And also the main highlight reason Warren Buffet, who backed Index Funds.

But here's a problem. All this hype for Passive Fund is not exactly logical. And there's some missing information in the message that is being passed by these 'Financially Aware Influencers'.

What is the problem?

The hype isn't exactly Indian. Almost all the authors of the books and even Warren Buffet himself are speaking from the perspective of USA's Financial Markets. Have you ever seen any pages that recommend you Index Funds using the data of Indian Markets? Probably not. Because in the US, the case of Index fund is true. But from the perspective of India, it is misleading. Here's how:

In the US, it is so difficult for active fund managers to outperform the benchmark index because the markets are efficient. What we mean is the proportion of the population participating in the market of the USA is more than the proportion of the population participating in the market in India. Hence, the US market is more Information efficient than the Indian Market. Due to this market inefficiency, the fund managers in the Indian Market have an extra edge over others to gain more returns.

And hence in the US, it is even difficult to gain 1% more than the benchmark, while in India for some funds the performance is even more than 4%, and that too over a longer period of time. Note here that the 4% difference is after adjusting the expense ratio. And a 4% difference over 20 years could double your portfolio amount. But are we going to just talk about it or going to present some data to back our argument?

Well, here you go.

Let us look at Nifty50 TRI's Average Annual Return in the past.

10 Year TRI - 10.96%

15 Year TRI - 12.60%

20 Year TRI - 14.08%

The Large Cap Category's Average in the past 10 years is 10.6%

(just 0.4% less than Nifty 50 TRI)

Let us specifically look at the number of Actively Managed Funds that outperformed Nifty50 TRI in various periods.

10 Years - 12/26 funds have outperformed - 46%

15 Years - 6/15 funds have outperformed - 40%

20 Years - 6/8 funds have outperformed - 75%

So at least 40% of the funds have outperformed Nifty50 in the past years. But as they say past data does not decide the future, let us look at some futuristic data.

Less than 2% of the Indian Population invest in the stock market against 50% of the population in the USA, and 7% in China. The AUM of the Indian Mutual Fund Industry stands at a mere 11% of GDP compared to 120% of GDP in the US. And due to this gap and information inefficiency, there is a bigger room and hence a bigger chance for the fund managers to outperform the market.

Also, the TER of the Active Mutual Funds has been falling year on year, thanks to SEBI. The difference in expense ratio between Axis Bluechip Direct and UTI Nifty Index Direct Fund is 0.41% and it has outperformed the fund by 3% in the past 5 years.

Note - We have selected top-rated Active Fund and top-rated Index Fund for the comparison.

The bottom line is that there is still time for Passive Funds to make their mark in the Indian Finacial Markets. Until and unless the gap between the market participants and non-participants decreases, there is still room for Active Funds to outperform the benchmarks.

Our Point of View - What should you do?

We are of the opinion that if you don't have the time or the knowledge and also don't have access to a good Financial Planner/Advisor, then you can go for Index Funds as your interaction requirement is bare minimum. If you have faith in the benchmark that the fund follows like Nifty50 or Sensex, then nothing much is needed from your end. Choose a good plan with a low tracking error and a low expense ratio

But if you have an access to a Financial Planner or the knowledge and the time to research Mutual funds, then definitely you should go for Active Funds. Because the time and the resources utilized behind Active Mutual Funds will always have a better chance to provide you enhanced returns than the benchmark.

This being said proper consultation and proper awareness is necessary and thus always consult a good Financial Planner before making a decision.

That is it for this week's FinMail, we will see you next week.

Source: ValueResearch, TheHindu, AMFI, Financial Express.

Calculation Method: CAGR