The Hindu Business Line : Weak case for index funds

What are your views on having index funds like UTI Master Index and LIC Sensex Advantage plan in a portfolio? What percentage of the portfolio should these index funds be?

Ankush Malhotra

We hold the view that actively managed equity funds should make up the lion's share of your portfolio. In India, such funds have consistently delivered much higher returns than the passive index funds, year after year.

In fact, the extent of out-performance has been so large that investors who invested in index funds would have suffered a sizeable loss of opportunity.

Over the past five years, for instance, active equity funds have generated returns of 15-20 per cent per annum, on a compounded basis (see Table).

But the Nifty and the Sensex have only managed about 6 per cent a year.

Such a large deficit in returns can make a big difference to the wealth you accumulate over a period of say, 5, 10 or 15 years.

There is also the issue of timing. The timing of your investment plays a greater role in determining your returns from an index fund, than would be the case with an active fund.

Investors who entered an index fund when the Sensex crossed the 6,000-mark in February 2000, would have a poor return to show from their investment.

Whereas, those who invested in an active equity fund, would have managed a healthy 15-20 per cent return over the same five-year period.

Index funds are actively advocated by investment advisors in the developed markets. However, under Indian conditions, many of the arguments that are advanced for index funds don't seem to hold good:

Index funds are said to be a good option because a majority of active funds in the developed markets struggle to beat the index.

If they do, they only beat it by a small margin. But active funds tend to beat the indices by a substantial margin in India.

What is more, the majority of active funds manage to beat the indices. This weakens the argument for index investing.

Index funds may make sense if the indices accurately capture the action in a substantial portion of the marketplace.

But in India, it is possible for a fund manager to unearth a large number of opportunities from outside the limited universe of Sensex or Nifty stocks.

Indeed, with mid cap stocks doing exceptionally well over the past couple of years, most of the big money-making opportunities in the market have come from outside the Sensex or Nifty.

Diversification is one of the benefits that index funds are supposed to provide.

But with the indices themselves made up of just 30 or 50 stocks, many diversified equity funds in the Indian context offer much better diversification than index funds.

In fact, the indices themselves suffer from high weightages to certain sectors, which may make them more risky than some active funds.

Index funds in the Indian context, do not offer a substantial cost advantage over active funds.

The latter charge more, but their returns more than compensate for the higher costs of running these funds.

Aarati Krishnan

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