Is it time to switch to index mutual funds?
The discussion gains currency in the backdrop of the failure of most actively-managed large cap funds to beat their benchmark index last year.
It is one of the hottest topics debated these days: is it time for mutual fund investors to switch to passively-managed index funds from their actively-managed funds. The discussion gains currency in the backdrop of the failure of most actively-managed large cap funds to beat their benchmark index last year. The Nifty (universe of top 50 stocks) has given around 11-12 per cent returns in the last one year, whereas most large cap funds have managed to offer only around seven per cent returns in the same period.
The recent re-categorisation of mutual funds schemes by Sebi has also contributed to increase the popularity of index funds in India, which have always been popular in the developed countries.
As you must be aware that index funds are very low on cost and do not involve an active fund management. They are also immune to any human biases. Index funds simply replicate the underlying Index. You can even buy the ETFs (exchange traded funds) directly. The expenses in ETFs are lower than index schemes. You must have a demat account to buy an ETF.
Though the gradual shift has started taking place towards index funds, only time will tell how fast they will gain popularity. So, does that mean that you should move to index funds completely and ditch your actively managed funds?
I think it is way too early to think that way because an active fund manager will strive to generate better returns than a passive index funds. An active fund manager will always focus on generating the alpha, especially, given the fact that our market is still developing. Often, an investor makes a mistake of comparing Indian market to a developed market like the US and believe me that is not an apple-to-apple comparison. The stock market in the US and other developed countries are matured and investing a big pie of your portfolio towards index funds there makes more sense. But the Indian stock market is yet to achieve that kind of maturity and to top it all our market capitalisation is way behind than what it is in the developed market which gives an added advantage to an active fund manager for creating better returns than an index fund.
Then there other important reasons like the flexibility, what an active mutual fund manager has in picking up the qualitative stocks in order to outperform the passive index funds. So, as long as the fund manager is good in generating the alpha, the fund will keep beating the index fund which only copies the benchmark indices, thereby making you lose the possibility of making higher returns.
Historically, mid cap and multi cap funds has always outperformed the index funds but in the recent past these categories have resulted in a negative returns and even the large cap funds have given lesser returns than an index fund. In fact, large cap funds will find it more challenging to outperform the index fund in the coming days because of re-categorisation: the fund manager of a large cap fund is mandated to buy most of the stocks from the top 100 companies. They have to follow true-to-label philosophy and stick to the mandate of large cap category. This mandate offers them very little chance to constantly beat the index. Prior to re-categorisation, fund managers had the freedom to buy stocks outside the universe of the top 100 companies.
There is another interesting reason why an active fund manager could not beat the returns of an index fund. In fact, more than 80 per cent returns of Nifty stocks came from a very handful stocks like Reliance Industries, Axis Bank, HDFC Bank, TCS, ICICI Bank and Infosys. This is the answer to the question most investors kept asking: why did my fund fail to generate returns when the market was soaring to new highs.
Well, looking at the market and the way it will shape in future, a lot of money will flow into the top 100 companies via the index funds, and the awareness will also increase. I believe you should gradually shift 20-25 per cent of your portfolio towards index funds. And don’t go only for index funds based on major indices like the Sensex or Nifty. Add the next nifty 50 index or the second best 50 companies in the Indian stock market.
In short, you should create a good mix of index funds that match your risk profile. However, you should not ignore the value of an active fund and the power of mid caps and small caps, so focus on investing in the right mix of index funds (replace large cap funds with pure index funds). If your risk profile is aggressive, go for some small caps also via SIPs which always works and provides you the cost averaging and thereby consistent returns in the long run. There are lot of good mid cap and multi cap schemes which haven’t performed in the past few years, thereby, making it a good time to enter in to those schemes via STP or SIP mode.
(Rishabh Parakh is Chief Gardener at Money Plant Consultancy)