Taking the index fund route on equities

With a majority of diversified schemes performing below benchmark, one could look at this alternative.

The numbers aren't too pleasant for a mutual fund investor. Sixty-five per cent of actively-managed mutual fund schemes have returned less than the Nifty, the benchmark index on the National Stock Exchange, in the past five years, says rating agency Standard & Poor's.

"Diversified equity funds, which offer a wider choice of stocks than large caps and, therefore, a greater chance of generating excess returns, also underperformed their benchmark but to a lesser degree. Equity-linked savings schemes (ELSS) have also fallen behind benchmarks in the same period," said their report.
 

THE LOWER, THE BETTER
	Tracking error *
Goldman Sachs Nifty ETS	0.09
Kotak Sensex ETF	0.13
Goldman Sachs Nifty Junior BeES	0.25
UTI Master Index	0.35
Tata Index Sensex B	0.37
Kotak Nifty ETF	0.40
* As on August 31, 2011 Source: Value Research

For the investor, grappling with volatile market conditions, it is an important question whether he should take a risk with an actively-managed fund or go or safer options in the MF space such as index exchange-traded funds.

Sandeep Dasgupta,CEO, Bharti AXA Investment Managers, says, "Index funds are for those looking to invest in the stock market and, yet, are not willing to take excessive risks." Another advantage of investing through an index fund, especially in these times, is that these are passively managed.

This means the scheme invests the money according to the index and, hence, there is little risk of active management. Whereas, one wrong call by the fund manager of an actively-managed fund in a bad market may lead to heavy losses, though these funds tend to outperform benchmark indices in good times.

Then, there is a cost benefit. Most index funds charge 0.5-1.5 per cent as annual fund management fees, whereas equity diversified funds can charge between 1.5-2.5 per cent.

"Passive investing is good and helps bring some amount of safety in the portfolio. But the problem in case of investing in index funds is the tracking error," says Radhika Gupta of Forefront Capital.

Index funds are supposed to mirror the underlying indices - Sensex, Nifty and others. However, there is a slight difference in returns of the underlying index and the MF scheme, called tracking error. Globally, this error is plus or minus one per cent, but it is more in many

cases here. As on August 31, the tracking error for the LIC Nomura MF Index Sensex was 1.61, the Taurus Nifty Index had 0.92 and ICICI Prudential Nifty Junior Index had 0.87 (source: Value Research).

Therefore, Gupta suggests investing in funds with the lowest tracking error. "That can be done if one has the numbers in place. Taking help from professionals would help in these situations," she says. Some funds with low tracking error are Goldman Sachs Nifty ETS, 0.09, and Goldman Sachs Nifty Junior BeES, 0.25.

In the past year, equity diversified funds have returned a negative 13 per cent, according to MF rating agency Value Research.

Index funds such as Goldman Sachs Nifty ETS have returned a negative 12 per cent. Others such as Franklin India Index NSE Nifty (tracking error = 0.49) and HDFC Index Sensex (tracking error = 0.61) have returned between negative 12 and 12.50 per cent.

"An equity diversified fund invests in some high beta stocks (mid-cap). Hence, it is bound to fall in an uncertain market. But, you need to remember that these funds are capable of outperforming the index in a good market," said a fund manager.

He says the returns also depend on which period you are looking at. At this point, index funds could be a good point to start. However, for those looking at a horizon of five to 10 years, equity diversified funds are recommended, as uncertainty is averaged out in the long run.