Is index-aping lucrative?

Publication: Business Standard;   Date: Aug 9, 2009;    Section: Marketing & Investing

Why a well-managed and diversified fund will always beat a benchmark.

A lot has been written about index funds in the past two years, with most proponents recommending it as a key component in a portfolio. The overall argument being that most diversified equity funds are unable to beat the index, just as in the case of Western markets. The other point was that index funds were a low-cost alternative to exposure in the stock markets. On the other hand, most asset management companies prided themselves on their active stock picking skills and hence made a lot of noise with their performance statistics during bullish periods. Do index funds really do better than actively managed funds in India?

First, let’s understand some basic definitions.
Index Fund: An index fund is a mutual fund scheme that will mirror a stock market index and invest in stocks that are part of that index in the same proportion. For e.g India’s widely followed stock market indices are the BSE Sensex and NSE’s Nifty 50. Most of the 21 index funds in existence follow either of these two.

Tracking Error: It is a measure of how closely a scheme follows an index to which it is benchmarked. Since an index fund is an imitation of the Sensex or Nifty, it is fair to assume there will be no tracking error. However, the reality on the ground is completely different and the tracking error varies between 0.3 to 2 per cent, plus or minus.

Expense Ratio: This is the annual fund management charge by mutual funds. This is charged on a daily or weekly basis and varies between 1.7 to 2.3 per cent p.a . Index Funds have an expense ratio of 1-1.5 per cent.

Let’s take a look at some performance figures. This data is based on pure NAV and excluding an entry load of 2.25 per cent.

If you look at the above data, it is very clear that some of the well-managed diversified equity funds have clearly outperformed the index. The difference in outperformance is not small, but as high as 5-18 per cent in a one-year time frame, 5-9 per cent each year across a three-year time frame and 8-12 per cent ever year for a five-year period. This is a huge gap and is one that typically happens in strong bull markets. One will find similar outperformance during the bullish phase of 2003-2007, where a lot of well managed diversified equity funds beat the benchmark index.

However, once the equity markets entered a downtrend or even a trading range, a lot of funds were unable to beat the index and hence the entry costs mattered a lot. The consistent ones, though, have done a fine job in bearish periods, too. Besides the huge gap in returns, there is some tracking error of index funds that are visible, too.

Let’s understand how a well-managed equity fund could beat the Sensex. The Sensex is an index made up of 30 stocks which have an unequal weightage in the index . For example, Reliance Industries accounts for a 13.65 per cent weightage in the Sensex. Similarly, Infosys has 8.7 per cent and ICICI Bank has 7.41 per cent. These three stocks put together comprise about 30 per cent of the index and the top 10 stocks have a weightage of 67 per cent.

The other 20 stocks, some of which are Tata Motors, Jaiprakash Associates, Hero Honda, Reliance Infrastructure, Tata Steel, Maruti , Hindalco , Wipro and so on, form a very small percentage of the index. Now if the top 10 index stocks do not perform well, but the balance 20 stocks do well, the impact on the Sensex will not be huge. At the same time, if a diversified equity fund has a Tata Motors weightage of 5 per cent in the portfolio (versus 0.92 per cent in the Sensex) and Sterlite of 5 per cent (1.62 Sensex weightage) in the portfolio, an outperformance versus the Sensex is quite likely, as stocks that have doubled or tripled from low levels form a sizeable composition of the portfolio.

The best eight stocks of the Sensex that have delivered stupendous returns since March 2 are Jaiprakash Associates, Tata Motors, Tata Steel , Hindalco, M&M, Sterlite, DLF and Reliance Infrastructure. But, these just comprise 11.89 per cent of the Sensex. Each of these stocks have delivered anywhere between 167-290 per cent in the past several months. However, the impact of the outperformance has been negligible and this is the reason why actively managed large-cap funds, which had a higher proportion of these stocks have done well.

With this data and those over the past several sharp bull markets, one can conclude that during sharp rises and strong bull markets, a well managed, consistent and diversified fund can beat index funds by a huge margin. The argument of low cost, which until now was present because of the entry load in diversified funds, should be history as even diversified funds will be no-load from here on. At the same time, the expense ratio plus tracking error of index funds is equal to the expense ratio of sizeable diversified equity funds.

The conclusion is that low cost is not always better and the low cost theory advantage of index funds, which is now non-existent, could come at the cost of performance.

The author Amar Pandit is director, My Financial Advisor

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