Still to gain ground

Index funds are cheap and need not be actively managed, still they are not on investors' radar screen.

Equity mutual funds are fast catching on as an acceptable investment option for a lot of investors.

This is mainly because factors such as favourable tax regime, effective investor education, the ease of systematic investment plans (SIPs) and, of course, impressive returns have made these funds look attractive to the potential customer.

However, it is surprising that index funds, one of the most cost efficient mutual fund vehicles, are largely being ignored by investors. These are basically mutual funds whose underlying investments mirror the constituents of a particular benchmark.

In India, such funds are based on mainstream indices such as the BSE Sensex and the NSE Nifty 50. In other countries, they are based on sectoral indices, such as banks or metals.

The advantages of investing through index funds include:

No fund manager risk: One of the biggest grouses that investors have against funds is that their hard-earned money is often rendered hostage by higher than warranted rotations amongst fund managers.

Well, this risk is obviated in an index fund. Here, the fund manager does not enjoy discretionary powers regarding asset allocation. The funds are merely invested in the same stocks as comprised in the underlying benchmark and that too in the same proportion.

Low cost: The recurring expenses charged by index funds are much lower than those charged by their actively managed counterparts. There are two reasons for this: One, as there is no need to hire star fund managers, their remuneration is not a big expense head. In fact, many a time, junior fund managers are assigned the task of managing index funds. Second, as the portfolio comprises large-cap stocks which are more liquid, the impact cost of transactions is also lower. Securities and Exchange Board of India (SEBI) has also mandated that index funds' recurring expenses be limited to 1.5 per cent of the corpus as against 2.5 per cent allowable for diversified equity funds. In fact, in the US the recurring expenses in index funds rarely exceed 0.5 per cent.

No entry loads: Most of the index funds on offer, do not charge any entry load. This is in stark contrast to most diversified equity funds, which charge around 2.25 per cent as entry load.

One reason for index funds not catching on is the perception that their returns are inferior to those of actively managed funds. But this perception has a valid basis, till recently.

That is, while it is true that actively managed funds have outshone index funds over the past ten years or so, this difference has narrowed steadily recently. The primary reason for this has been that the Indian market is getting more and more 'discovered'.

This is because till five years ago, the universe of broker research on companies was restricted to the front-line performers. The middle and low rung companies were seldom researched.

Hence, that offered a hard working fund manager to take advantage of the situation and give returns by investing in stocks where there was little or no research available in the public domain.

However, things have changed dramatically now. More and more mid-cap companies are being covered by brokers and consequently, the probability of earning supernormal returns from them has come down. In developed markets like the US, many of the actively managed funds have struggled to beat the broad indices for the past couple of decades.

Yes, the road looks good for index funds. But what about the downside? The only one is that a particular fund may lag the index returns due to a phenomenon known as 'tracking error'.

This is a measure of how closely the portfolio follows the index, and is measured as the standard deviation of the difference between the portfolio and index returns.

Usually, index funds suffer a tracking error of 0.5 per cent to 1 per cent. Considering that India is still some way off from joining the league of "emerged" or "developed" markets, there is still ample scope for generating returns through actively managed funds. However, it is certainly worth allocating some portion of your investible surplus in index funds considering the advantages that they possess.

The writer is a certified financial planner