As several actively managed funds have been unable to beat their benchmarks consistently, many investors are moving to index funds for higher returns. Out of 31 large-cap mutual funds, only four have beaten Nifty in this calendar year. And with valuations remaining elevated, especially for large-cap stocks, prospects for alpha generation are limited.
Passive gains
In November, the net inflows in index funds were Rs 8,601 crore, or 3.8 times more than all equity-oriented schemes. Large-cap funds saw an outflow of Rs 1,039 crore in November. The lower expense ratio of index funds which offers a cost advantage of around 100 basis points has made them much more attractive to invest.
Harshad Chetanwala, co-founder, MyWealthGrowth.com, says over the last few years, index funds have outperformed many actively managed funds and this has been one of the strong reasons for investors to consider these funds. “Investors also consider these to have lesser risk as the investment happens predominantly in index companies,” he says.
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With top five constituents accounting for 40% of weights and top 10 accounting for 58% weight on the Nifty 50, most performance for the index was driven by the heavyweights. Nirav Karkera, head of research, Fisdom, says extraordinary performance by select stocks like Adani Enterprises was missed by almost all actively managed funds, while strong opportunities presented by heavyweights like HDFC Bank and RIL could not be capitalised upon beyond a point, due to regulatory restrictions on single-stock exposures. “Many active managers did not quite recognise any exit opportunity as good enough to exit or trim exposure to index heavyweight technology stocks held through last year, which disappointed in the current year,” he says.
How to select an index fund
As there are different kinds of index funds, investing in a well-diversified index could be a good strategy. Sectoral index funds carry higher risk as they invest only in one sector. Ideally, Nifty 50 Index Fund or a Sensex Index Fund can be a good option.
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Feroze Azeez, deputy chief executive officer, Anand Rathi Wealth, says investors should keep in mind that as index funds follow a benchmark with a tracking error, there is a potential for a 1% alpha loss. “As the category follows the benchmark, it does not have high downside protection when compared to any actively managed fund,” he says and adds that investors should understand the alpha generation potential of the other categories before investing in passive funds.
A blend of active and passive funds could be a better strategy instead of going for all passive. There still exists potential to invest in companies that can generate better returns than some of the index stocks. At the same time, some stocks may not be part of the index but have good business opportunities, these companies can get invested by actively managed funds.
As in the Indian market there is a lot of potential to generate alpha, Azeez says it is not a wise decision to forgo the alpha which can significantly improve the portfolio performance. “It is advisable to create a portfolio with a mix of large, mid and small-cap funds with 50:30:20 exposure in each category,” he says.
Eliminates bias
Fund managers tend to follow certain investment philosophies and styles such as growth, value, based on which they construct and manage fund portfolios. Dhaval Kapadia, director, Investment Advisory, Morningstar Investment Adviser (India), says since index funds passively track an underlying market or strategic beta index, there’s no active fund management decision involved, thereby eliminating fund manager biases. “Of course, smart beta funds focus on certain factors or styles, the performance of which could be driven by the prevailing market cycle,”he says.
Like with any quantitative rule-based investing framework, even indices are managed with a clearly defined mandate.
“At a fund level, index funds are insulated against behavioural biases except for the highly improbable instance where the methodology itself is modified basis the management team’s ideologies. However, the number and variety of index funds available along with the investor’s prerogative to allocate still leaves a portfolio of index funds susceptible to an investor’s biases,” says Karkera.