Divergent Index Funds

Suresh Krishnamurthy

IN THE backdrop of the investor's focus now on reducing risk rather than enhancing returns, index funds appear to have become prominent. However, investing in index funds may not be such a good idea now because the indices are at a particular low.

When stock prices rise, actively managed funds stand a better chance of outperforming the indices. For example, in the last one-month, mutual fund equity schemes, on an average, generated 10.4 per cent while the Nifty gained 7.5 per cent. A majority of the funds outperformed the indices even over a longer period of three years or so.

Still, index funds do have a place in the portfolio of a conservative investor. No investor is in a position to know when the market will decline and when the declining trend will end. In that context, a conservative investor would be comfortable with an index fund that can be expected to perform better than actively managed funds during a decline.

However, choosing a particular index fund is not that easy. This is because of the significant divergence in the performance between Nifty and Sensex. In the three-year period ending November 15, Nifty has turned in a return of around 21 per cent while Sensex has gained by 8 per cent. Even in the last year, Nifty has out performed Sensex by around 2.5 per cent.

Does this automatically suggest that an investor should opt for Nifty funds rather than Sensex funds? No. Though index investing is a passive strategy, choosing between the two funds is an active one. The choice, therefore, should be based on research and not merely on past index performance.

However, if an investor wants to adopt a passive strategy, even in choosing, he would be better off allocating equally between the two funds. The allocation would, however, need to be balanced at periodic intervals.

Better-informed investors can use index funds also as an active strategy. If they are aware of the reasons that are behind the divergence in performance, they can switch between Nifty and Sensex funds depending on which fund is likely to outperform the other.