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Should you shift from large-cap mutual funds to index funds?

, ET Online|
Updated: Dec 06, 2018, 11.19 AM IST
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Index funds are suitable for investors who are want funds with low cost and without dependence on fund manager's intervention.
The index fund category of mutual fund schemes is slowly gaining traction among investors. The fortunes of index funds are changing as not only are they being given a serious consideration, there are industry experts who are even suggesting replacing large-cap schemes in one's portfolio with index funds.

"In India actively managed funds will continue to outperform because fund managers have leeway of buying some percentage of stocks beyond the benchmark index, however, going forward especially for large-cap based active funds it will be difficult to beat benchmarks," says Lav Kumar, Head Products & Business Development at LIC MF. He adds, "In my view large-cap allocation can be shifted to index funds."

Why index funds are on the radar now
Two important regulations in 2018 by Sebi, the market regulator, have put index mutual funds on the radar of several investors. One, the recategorisation exercise undertaken across schemes including equity schemes and second, the disclosure of schemes' performance as against the total return index (TRI) that includes the impact of dividends earned by the underlying shares of the index benchmark.

Both of these factors may not directly impact index funds but still have a role to play in the rising popularity of these schemes. "Re-categorisation can prove to be the trigger for the popularity of index funds in India. All this while, schemes were being managed based on the whims of the fund manager with no truth labelling. There were large-cap funds with 20-30 percent allocation to small- and mid-cap stocks. As a result, most large-cap funds used to outperform the benchmark by a wide margin and investors were unable to ascertain the risk that the fund managers were taking to generate this outperformance," explains Raghvendra Nath(CFA), MD at Ladderup Wealth Management.

Outperformance of a scheme appeared to be more but now when compared to the TRI, the difference will be less. "Earlier the dividends from underlying stocks typically used to compensate for the expense ratio and brokerage or impact costs. Now with dividends getting added in the TRI benchmark, the benchmark returns will increase to that extent. Hence, the performance of index funds vis-a-vis their benchmarks would be marginally impacted," says Prasana Pathak, Fund Manager- Equity at Taurus Asset Management.

And this is true for every equity scheme including actively managed schemes as benchmarking will be against the TRI benchmark. "With this new re-categorisation and benchmarking against TRI, there is expected to be a low disparity between active funds and passively managed index funds in terms of returns. It is rather expected to see a gradual uptick in AUM for an index fund going forward given its low cost dynamic," says Dinesh Rohira, Founder and CEO at 5nance.com.

Post the 2018 regulatory changes by Sebi, the recent performance of index funds (passive fund management) against funds with active management are getting noticed. "These changes are already visible in the performance of the funds in last six months where a large number are already under performing the benchmark. While six months is not a sufficient period to make a judgment on the efficacy of active management, but one thing is sure, that the number of funds that would outperform the benchmark would come down as well as level of performance will also become narrower," says Nath.

IF

Will it be difficult for active funds to beat benchmark?
If the outperformance between active and passive funds is not going to be much, which categories of schemes are going to lag behind their benchmark?

"Recent SEBI guidelines mandate large cap funds to invest at least 80 percent of the portfolio in top 100 stocks which will lead to faster price discovery. In addition, large cap funds have a higher expense ratio as compared to index funds. Hence, going forward large cap funds may underperform index funds. In the multi-cap and mid-cap funds categories, however, there is wider latitude to invest and therefore these may continue to outperform comparable index funds," says Roopali Prabhu, Head of Investment Products, Sanctum Wealth Management.

On an average the total expense ratio (TER) of regular equity funds is around 2 percent while for index funds is much lower at about 0.85 percent. The TER for the direct plan of both these categories would even be lower further.

The passive management style keeps the volatility in index funds lower than actively managed funds. But, if there is no active fund management involved in index funds, the probability of generating 'alpha' is almost non-existent in them. The excess return that a MF generates relative to the return of its benchmark index is its 'alpha'.

This is where the role of a fund manager comes in. "There will be periods when index funds will outperform actively managed funds. However, in a developing economy like India, a good fund manager tends to catch a stock or sectoral trend much earlier than it gets reflected in the index. Hence, the probability of active funds outperforming is higher in the longer run, especially in the Indian context," says Pathak.

What are index funds?
An index fund is similar to any diversified equity fund but with a difference - a fund manager has absolutely no say in stock selection. At all times, the portfolio of an index fund mirrors an index, both in its choice of stocks and their percentage holding. Because of this correlation, the NAV of an index fund moves virtually in line with the index it tracks.

For example, if the Sensex rises 10 per cent in a month, the NAV of a Sensex-linked index fund will also roughly appreciate 10 per cent over the same period. If the Sensex drops 10 per cent, so will the NAV of the index fund.

Although index funds aim to mirror market movement, the returns tend to be marginally lower than the index they track. This variation is termed as 'tracking error', and occurs due to various costs an index fund has to bear such as brokerage, marketing expenses and management fees.

Who should invest in these schemes?
Beginners to mutual fund investing who could be students, those in their forties or even those nearing retirement, may consider index funds especially if it's their first brush with mutual funds. "It would be most suitable for an investor who wants to be on par with the index returns. Since it does not take any active call on the portfolio, there is no alpha which can be delivered by these funds," says Nath. Further, those investors looking for low volatility in returns, these funds come handy. "Index funds are suitable for investors who are want funds with low cost and without dependence on fund manager's intervention. These funds are also liked by investors who are aware about markets and composition of indices," says Kumar.

Types of index funds
Index funds can be either the ETFs listed on the stock exchange or schemes available with mutual fund houses. "Index funds offered by different AMCs in India are composite of mostly Nifty 50 and Sensex. These funds also partially include other indices like Nifty Next 50 and Nifty Junior, but most of the index funds are constructed on Nifty and Sensex," says Rohira. Some ETFs may be different in their underlying assets. "ETFs can be based on index funds or can have separate underlying stocks like CPSE ETFs and Bharat 22 ETFs series," informs Kumar.

MF schemes linked to different indices
Index MF Scheme
NIFTY 50 Equal Weight Index Principal Nifty 100 Equal Weight Fund
Sundaram Smart NIFTY 100 Eq Weight Fund
NIFTY 50 - TRI Aditya Birla SL Index Fund
HDFC Index Fund-NIFTY 50 Plan
ICICI Pru Nifty Index Fund
IDBI Nifty Index Fund
IDFC Nifty Fund
LIC MF Index Fund-Nifty Plan
Reliance Index Fund - Nifty Plan
SBI Nifty Index Fund
Tata Index Fund-Nifty Plan
Taurus Nifty Index Fund
UTI Nifty Index Fund
NIFTY 50 Equal Weight Index DSP Equal Nifty 50 Fund
NIFTY NEXT 50 - TRI ICICI Pru Nifty Next 50 Index Fund
IDBI Nifty Junior Index Fund
UTI Nifty Next 50 Index Fund
S&P BSE SENSEX - TRI HDFC Index Fund-Sensex
ICICI Pru Sensex Index Fund
LIC MF Index Fund-Sensex Plan
Reliance Index Fund - Sensex Plan
Tata Index Fund-Sensex Plan

How much should you invest?
For an investor who has linked the equity MF investments to their long-term goals, diversification across different categories helps. "Ideally, an investor should hold about 20 percent of index funds in an overall portfolio. This can go up to 30-40 percent for risk-averse investors," says Rohira. Overall, a passive investor may consider a higher allocation to these funds. "This would depend on the objective of the investor and their risk appetite. If the objective of the investor is to get index returns, only then should he invest in index funds. Also, if an investor doesn't believe that the fund manager can make a difference or believes the fund manager will end up increasing the risk of the portfolio, then he can go for the index funds," says Nath.

Watchouts
"While choosing an index fund or ETF, investors need to look into aspects like the underlying index for the fund, the expense ratio, historical tracking error and ease of investing and service levels of AMC. For ETFs, additionally, one should check the liquidity on the exchange and the impact cost," says Pathak. With other factors constant, the lower the tracking error, the better is the fund. "A higher tracking error indicates a greater deviation in returns that should be avoided by investors, while lower deviation in returns should be the ideal preference," says Rohira.

What you should do
Over longer periods, for a fund manager to generate an alpha across different market cycles and economic conditions may not be feasible at all times. However, returns from index funds can be expected to be in line with that of the markets, no matter what the time horizon is. The top performing mutual fund scheme of today may not be the winner tomorrow or 10-years from now. Your index fund can be your friend for the long road with less bumpy ride.
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