Index funds are a relatively small part of the overall mutual fund industry in India, and this is markedly different from the west, where index funds do quite well, and in fact the biggest fund in the US is an index fund (SPY) that tracks the popular S&P 500 index.
I think there are two aspects to this – the first is that actively managed funds have performed better than index funds in the past and people expect that to continue in the future as well, and secondly, index funds aren’t really low cost in India.
First, let’s look at some data to see why I say actively managed funds have performed better than index funds.
To get this data, I took the list of mutual funds from my post on the best balanced funds and saw how they performed vis-a-vis GS Nifty BeES which is the biggest index ETF right now, and is fairly low cost as well.
Here is a table that shows the results.
| S.No. | Mutual Fund | 3 Year Return | 5 Year Return |
|---|---|---|---|
| 1 | Goldman Sachs Nifty BeES | 28.34% | 8.29% |
| 2 | HDFC Prudence | 38.64% | 14.94% |
| 3 | DSPR Balanced Fund | 25.05% | 12.37% |
| 4 | HDFC Children’s Gift Plan Fund | 37.61% | 13.85% |
| 5 | Reliance Regular Savings Balance Fund | 32.91% | 14.81% |
| 6 | HDFC Children’s Gift Plan Fund | 37.61% | 13.85% |
| 7 | Birla Sun Life 95 | 29.77% | 12.45% |
| 8 | FT India Balanced | 22.85% | 9.14% |
| 9 | Canara Robeco Balance | 30.31% | 12.04% |
| 10 | Tata Balanced Fund | 29.58% | 12.44% |
As you can see, with the exception of DSPR Balanced Fund and FT India Balanced Fund in the 3 year period, the balanced funds did better than the index fund in the 3 and 5 year periods. I’m sure there are plenty of other examples like this and in this environment it just isn’t possible for index funds to get popular.
The question then is why do active funds do better than index funds in India? I’ve seen several theories on this but none that seem very convincing. Perhaps the confluence of all the factors make them do better or it could be something that isn’t talked about at all right now.
The chief theory that I’ve heard a lot is that the markets in the west are so deep and developed that they are efficient to a large extent and it is difficult for stock pickers to find mis-pricings and benefit from them. Indian markets are not so efficient so stock pickers are still able to find undervalued stocks and benefit from owning them. While this may sound plausible, the thing that makes me a little wary of this theory is that markets in the west are quite volatile as well so people can take advantage of stock prices when they are low, plus there are a lot of hedge funds that do beat the market so it isn’t like the market is very efficient.
The second aspect is that of cost and tracking error of the index funds themselves. The whole point of an index fund is that it should be extremely low cost since there is no active management needed but that low cost hasn’t really materialized in the Indian market.
In March 2010 I did a list Nifty index funds and Sensex Index funds, and saw that a lot of them charge in excess of 1% recurring expenses and that’s simply too high for an index fund. Since then there have been funds that charge much lower expenses, most notably the IIFL Nifty ETF that has an expense ratio of 0.25% which is the lowest of any index ETF till date. The biggest Nifty ETF – Goldman Sachs Nifty BeES ETF is also a low cost ETF which has expenses of about 0.50% and has been around for a decade now, but as a category – the low cost has still not become a norm, and that makes a difference to the returns.
So, I would say that the two main benefits of investing in index funds – which is low costs and doing better than active funds have been more or less absent in India so far and it’s hard to say why. People who want the benefit of passive investing feel that by creating a SIP in an active mutual fund – you enjoy the same kind of benefit and the past returns show that it has been beneficial as well.
I don’t know whether this trend will change or not but keeping all this data in mind, it is hard to invest all your money in passive index funds.
This post is from the Suggest a Topic page.
@ A.R – I totally agree with you regarding John Bogle and his book and all the point you have said. But all those points make a lot of sense in the west esp. US as the market is stabilized compared to India. I am not totally sure how it will work out in India with these concepts since their still isnt a Vanguard like company or vanguard like funds in India. I have been trying to find an equal-ant to Vanguard in India for a while, but with no luck. The fees that they have for an Index fund (around .50% ) is very high. Over long periods of time, it tends to add up to a lot of monies. Let me know if you know of any company or fund which is not expensive and gives the desired results. Also, the issue is we do not have that long a history (20.25 yrs) to compare/analyze index funds in India.
@Manshu
The very first thing I would suggest is to read a book written by the father of Index Funds called “Little Book of Common Sense Investing” by John Bogle. Please do not take this as a means of me trying to lecture you. You will thank me after you have read this book.
I don’t tend to believe your findings because you seem to confuse a lot of issues.
1) The POINT of traditional Index funds is that they are invested in on time frames greater than 20 years. Talking about 3 and 5 year terms is just ridiculous.
2) I am happy to be proven wrong but I am convinced that the balanced mutual funds that you’ve listed do not OUTPERFORM the market as a whole. If they do not outperform the market AND have higher fees than Index funds, Index funds win over the long term for example a 20-something year old saving up for retirement at 60-65. Please back-test and prove me wrong.
3) TAXES! I don’t think you realize but every time someone trying to “play the stock market” by buying low and selling high, not only do they rack up transaction costs, but they also generate an income that is taxable which is usually taxed at the marginal rate. In the West, there is no tax on wealth that’s locked up in an Index Fund that is not realized. So what this means is that over 50 years, all the wealth that has grown through the beauty that is compound interest, is not taxed and you only draw down what you need for a modest lifestyle.
4) TURNOVER – Maybe in India, older generations of mutual fund managers had low turnover rates (certainly was the case in the west – Bogle’s book goes over this in much detail), but modern ones can easily turnover 100% of their stock holdings each year, the transaction costs associated with that will just eat into any gains made.
Look I’m not going to go any further, anyone reading this thread, get your hands on that book and hopefully you’ll understand.
I will add just one other thing. Understanding Index Funds requires a paradigm shift especially if you’ve been under the influence of other investment options.
Think about this; with mutual funds there are the following risks: market risk, manager risk, timing risk, transaction costs, additional taxation, sales loading, paying your fund manager’s exorbitant fees, any ongoing fees + whatever else that I don’t know. With Index funds, you only have market risk and ongoing fees. Which would you pick? Even if there is one TOTAL MARKET index fund out there, it would be worth investing in, diversity in available funds does not somehow magically reduces those risks/costs or generate better-than-market-average returns OVER TIME.
Hello,
I am an absolute novice in this field and do not even Commerce as my educational background.
I recently was adviced to put in some amount in Index funds…How to do that? Are there various types of index funds to choose from ? If yes, how to choose ?Would you advise me regarding this please.Do excuse the ignorance.Trying to learn.Thanks.
Buy CNX 500 from Goldman Sachs. Direct Growth Plan. There are other funds I do not recommend as they are too narrow (focus on top 30 or top 50 stocks).
Hello,
Thanks for your reply and guidance.
Time period of comparison is way too small, and there is absolutely no study across all funds. You’re picking funds ex-post i.e. you’ve picked high return funds. Unless this was compiled with ratings/ rankings before 3 years or 5 years i.e. on the date of picking the fund, it suffers from hindsight bias. Also, remember to compare like with like; you must compare the growth option with the total return index, and you must compare them for a period of 20 years. Nifty Bees pays a dividend that any investor should reinvest if he or she is serious about index investing. I have done the exercise of computing the sensex returns over 25 years, and it is well above 19% if you include dividend. Do you think large-cap mutual funds, or any portfolio thereof, will give you that kind of return at equal risk over such long horizons? Of course, balanced / diversified funds with holdings across BSE 100 should be compared with that benchmark; it’s returns are slightly higher than Nifty and Sensex.
You can look at http://www.crisil.com/pdf/capitalmarket/SPIVA_dec11.pdf
As of December 2011 – see page 6,
Percentage of funds outperformed by the benchmark
Fund category Benchmark index 1-year 3-year 5-year
===============================================
Large Cap S&P CNX Nifty 35.29 59.26 52.63
Diversified S&P CNX 500 46.26 45.83 57.83
ELSS S&P CNX 500 27.78 48.48 59.26
Hi Manshu
I really enjoyed reading your post. The reason I came here was because I was looking for low cost index funds in India and couldn’t find any :O Shocking!
Anyway, what you say about index funds not out performing actively managed funds is true in the short term. However, if you look at developed markets you will see that over the long term, index funds have consistently outperformed actively managed funds. These are the facts, the rest is just speculation.
Unless there’s a lot of insider trading going on, I think the Indian stock market – in the long term – will reflect the fundamentals of it’s more developed counterparts.
Unfortunately, I’ve been unable to find any reliable index funds with expense ratios of ~0.25% in India. The IIFL fund you mentioned has not been rated by CRISIL. Not sure of whether it’s good to go with.. also, there seem to be huge tracking errors on most index funds, I don’t understand why this is the case.. =/
Hi Manshu
Why has HDFC Children’s Gift Plan Fund appeared twice in your table?
That’s an error that I need to correct – thanks for noticing and bringing it to my attention.
That’s why I started investing in NPS, world’s most cheapest index fund. And due to several reasons
1) The equity part is in index of course
2) Expense ratio is laughable even after considering all other costs
3) Forced long term investment enforcing discipline
4) Regulated and monitored by Government (don’t consider that to be income guarantee :))
5) Currently EEE and highly doubt whether it well ever be anything other than that
6) You can play around with percentage allocation
NPS does not have the best of the feedbacks. But I think in few years it would be more streamlined and I hope government would not stop this retirement savings avenue.
I looked at the equity returns a few months ago and they were not doing too well even when compared with the index….has that changed now? Have you looked at the numbers recently? Thanks!
Nope, I don’t have the recent numbers. I have the following till 2011:
http://articles.economictimes.indiatimes.com/2011-05-02/news/29491227_1_fund-managers-new-pension-scheme-nps-lite
http://paycommissionupdate.blogspot.com/2011/05/new-pension-scheme-returns-in-2010-11.html
I think 2011-12 pfrda review is up in few months.
Report from pfrda for 2011
http://www.pfrda.org.in/writereaddata/linkimages/PERFORMANCE%20SHEET_%20MARCH%2031_20112595365271.pdf
Oh wow – thanks for looking that up! Kind of weird how Kotak and ICICI are doing better than the others and that too looks like so much better. I wonder how that is.
The three big reasons are:
1. Index funds buy high, sell low as Index funds largely track the market capitalization of companies that form part of the index. So as a company gains in market capitalization (and thus gets expensive in terms of valuations like price-to-earnings or price-to-book value), the index fund manager has to buy more of it to get it to a higher weightage in his fund as well.
2. Index funds buy the past, ignore the future
Index funds tend to have the most significant portion of their assets in large, mature companies, many past their prime and with years of stagnation or decline ahead of them.
3. Index funds stick with stocks till they’re kicked out
The ranking of the 30 largest companies in India changes nearly every second as stock prices fluctuate up and down. At the bottom of the table, some companies drop out of the list while other companies manage to sneak into the top 30. Since index fund managers have to follow the indices’ portfolio weights in order to minimize their tracking error, they hold on to the dropped companies till the last second while active managers sell them weeks or months before they’re dropped from the index (and for other reasons that are related to business performance instead of stock market performance).
Index fund managers also don’t start buying the newly added companies until they’re officially added while active managers already have the new (and better) stocks in hand.
This point is supported by graphs for companies like Mahindra Satyam, Reliance Communications, and Reliance Infrastructure that were deteriorating businesses for more than a year before they were excluded from the Sensex.
1. Index fund is a buy and forget strategy, meaning once you invest in the stocks of the Index in the same proportion, you dont have to rebalance the portfolio. The portfolio mirrors the index by itself. Thats the beauty of an Index Fund. The only time you need to rebalance is when you have a sufficient subscription, redemption or Index Maintenance.
2. The job of the Index Fund is to mirror the Index, not to go into the merits of the stock on the Index. Thats the job of the Index cells at the Exchanges (IISL in case of NSE).
3. The replacing of stocks in the Index is routinely called Index Maintenance, and this does not happen so frequently. Every quarter, the Index cells takes a call if any Index Maintenance activity is required, and the annoucement is made well in advance (of course, corporte actions like mergers & acquisitions, require more frequent Index Maintenance). For an Index Fund Manager, there is no point buying the incoming stock in advance or selling the outgoing stock in advance. He needs to do it on the day of the Index Maintenance and during the last half an hour of market closing. This is because his traded price needs to be as close to the Stock Closing Price and the Stock Closing Price is the weighted average price of the last half and hour of trading. If the Index Fund Manager buys or sells in advance, he will only increase his tracking error, which is the primary yardstick for measuring his performance.
A doubt why did you compare with balanced funds and not equity diversified?
The first thing that came to my mind was that they aren’t popular because the perception is that active funds do better, now how could I check the perception? I remembered that I had this balanced funds list and so I thought of checking their returns first. And that itself showed why the perception exists so I didn’t bother to find more data though Nitin’s data confirms this perception much better than just these 10 stocks.
Could it be that Indian indices Nifty or BSE weightage is primarily on market capitalization?
You can have a CNX 500 index fund, doesn’t mean the weightage is equally split across 500. It is still going to be top heavy. 50 stocks accounting for 99% in the portfolio. The 450 accounting for nothing.
The 450 will definitely have stocks that are undervalued, attractive, solid fundamentals with growth spurts or momentum surges on a 3-5 year span.
If you are a fund manager, the way to beat it would be to churn your portfolio to shift bias towards those 450 and pray to hit big.
It is like cricket captaincy, move a fielder to someplace, a catch goes there, captain is genius. a 4 goes, he is a moron.
at the end of the day, it is still a crap shoot.
Bottom line : No fund manager will stay for 15-20 years (excluding exceptions0 . Compare 15 yrs vs the index.
In less than two decades, Exchange-Traded Funds have become a major type of investment around the world. The first ETF was launched in the US only in 1993 and in Europe in 1999. Today, a huge USD 2.3 trillion of assets globally are deployed in ETFs. The first Indian ETF was actually launched as long ago as 2001 by Benchmark Mutual Fund, an AMC that has since specialised in this type of fund, now acquired by Goldman Sachs. ETFs are less than 1 per cent of the total assets of Indian mutual funds. Even out of that, a big chunk is Gold ETFs.
Nearly 70 per cent of the equity assets today lie with the diversified equity funds, while sector funds manage 17 per cent. In the thematic category, infrastructure funds managed the largest amount of money at around Rs 20,000+ crore inspite of lacklustre performers in the past years. The two consistent top quartile performers from the HDFC stable – HDFC Top 200 Fund and HDFC Equity Fund – are the largest schemes each managing more than 9,000 crore of assets. The top ten funds manage assets worth Rs 3,000 crore or more.
As you rightly pointed out, Indian investors have almost completely ignored these funds. Only audience that index funds or ETFs can possibly have is self-driven, knowledgeable investors who understand what they are getting for they are not recommended by the TV experts, magazines or mutual fund agents.
Secondly the returns, people invest in Mutual funds to get returns. The equity funds have outperformed Sensex or Nifty.Maybe In a rapidly evolving economy (and stock market) like India’s there’s so much happening all the time in terms of businesses changing, evolving, growing and simply participating in the enormous pockets of growth, that there’s plenty of room to identify and exploit opportunities. Expense ratio does not figure much in choosing the funds.
Quoting from Valueresearchonline:How Funds Outperform Markets
However, there’s another side to this story which some people believe in, that maybe the Indian indices are easy to beat. At the end of the day, neither the Sensex nor the Nifty are designed as investment portfolios. Both the indices are based on a number of parameters. The Sensex apparently bends towards being representative while the Nifty has a more numerically driven criteria that is focused on liquidity, measured by low impact cost of trading.
While the day may yet come when things change so much that index funds and ETFs become the logical choice, it probably won’t be any time soon.
So Investors have made a beeline for the most consistent performers among equity funds, placed most of their bets on plain-vanilla schemes including me personally!
I don’t buy the argument that Indian indices are easy to beat because of the way they’re constructed because of the way the Dow has been constructed and American funds still find it hard to beat! The Dow is a price weighted index and if you tried to make that type of index today you will be laughed at. As I said, there are many many theories on this but as far as I’m concerned, none that seem very convincing.
Just to add to the fact and figures presented, I can remember atleast 3 Index Funds which existed in India before Benchmark launched NIFTYBEES. They are Franklin Templeton India Nifty & Sensex Funds by Franklin Templeton India, SBI Nifty Fund by SBI Capital Markets and IDBI Principal Nifty Fund by IDBI Principal AMC.
The idea of an Index Fund is simple. Empirical data shows that in the long run (25-30 years), equity returns beats all other asset class returns. The Index Fund investors want to realise these returns. They are ready to forgo the excess returns that the active fund manager is offering since they believe in the Efficient Market Hypothesis, which says i simple language that it is not possible to consistent make above market returns over a sustained period of time.
Also the idea of an Index Fund is not to beat the Index (without going into the merit of the statement that Indian Indices are easy to beat), but it just needs to track the index.
Yes all investors invest in the markets to get maximum returns. But to get higher returns, one needs to take higher risks. We also know that returns are proportional to time horizon, while risk is proportional to square root of time horizon, hence increasing the time horizon leads to a favorable risk to return ratio. Hence, when dealing with equities, which are relatively volatile, take a longer investment time horizon.
Whenever MF returns are quoted, i find it funny with the return n.os.
as long as the 3 yr, 5yr returns include 2008,2009 – past performance of funds are going to be unbelievable.
seriously, the index tanked and regained after 2008-9. the fund managers are kidding themselves that they are the reason for the performance.
so remove the 2008-2009 blip , see the returns of the mutual funds right from their inception vs the index they track. Should be pretty interesting!!!
Glad to see you spelled Buffett correctly this time. 🙂
I think you are missing out the effect of Dividends – see my post http://nitnblogs.blogspot.com/2012/03/why-costs-and-tracking-error-are-not.html
Also the last 3 and 5 years have not been a good period for this comparison. Index funds require you to take a 10-15 year view.
Since the data is from Value Research – and is not absolute difference in the NAVs – it does include the effect of dividends in the GS Nifty BeES and the mutual funds schemes that I saw were all growth options so that is devoid of the dividend effect.
Have you seen anything which makes you think that the performance numbers in Value Research for Nifty BeES doesn’t include dividends in return calculation?
Also, why are the last 3 – 5 years not good for this comparison and has there ever been a period where this comparison would’ve shown that index funds outperformed active funds? Please bear in the mind the comparison mutual funds are balanced funds, not even 100% equity funds.
Thanks for your comment.
I am not sure if Value Research accounts for dividends or it just accounts for the NAV. The conclusive data is on http://www.benchmarkfunds.com/Documents/Factsheet.pdf which does indeed cover dividends.
I have a fundamental difference of opinion in the way this analysis has been presented. If I look at the data as of today on http://www.mutualfundsindia.com, there are 21 balanced funds that have been in existence for more than 5 years. In the last five years, GS Nifty BeeS has given a return of 7.97% per annum. 7 of 20 (~35%) balanced funds have underperformed NiftyBees. Actually a more appropriate comparison for Nifty Bees is DIversified Equity funds. Here out of the 137 diversified equity funds in existence for the last 5 years, 57 (~42%) have underperformed NiftyBees. For the last three years the data is 59 out of 157 (~31%) have underperformed. This data analysis was from http://www.mutualfundsinida.com. If we look at the 10 year picture, the data would show more underperformers (unfortunately most websites I see do not have 10 year data).
Add to this to the fact that we are looking at only the surviving funds. Many poorly performing funds have closed down or merged with other funds in this period.
Thus its safe to say that you have a less than 50% chance of beating the index in the long term with any fund. Yes there can be start performers however you have to go on tracking the top performers, continuously sell under performers and stomach the losses. The stars of today may be the duds of tomorrow. I would say even in the US there will be funds which beat the indices handsomely, but its the long term picture that makes it tilt in favour of index funds. In addition there is very little work involved in tracking and churning your portfolio.
You can see a note outlining the argument above at: http://nitnblogs.blogspot.in/2012/02/investing-in-muual-funds-using-olm50-or.html
I absolutely agree with you Nitin.
The analysis shown by Manshu compares the Best Balanced Fund with an Index Fund. Now this is no comparison. It is like comparing the percentage score of the first five students in the class with the class average and then concluding that the top five students have done better than the whole class.
Also I agree with Nitin as regards to time frame. In Equity Markets, 3 to 5 years is a very short time frame. One has to look at a time frame of more than 10 years.
Also the idea of an Index Fund is not to give you abnormal returns. So there is no sense in comparing a balanced fund to an Index Fund. What we should be comparing the Index Fund is with the Index it is tracking. And the measure of the same is the Tracking Error. As long as an Index Fund has a very low tracking error and a low managament cost, its doing great. As an Index Fund investor I am not really bothered as to how its performing vis-a-vis other funds. If one has such interest, he rather not invest in an Index Fund.
Why compare an index fund with just the index it tracks but ignore other products that could give you better returns with an equal risk exposure?
For anyone investing in equities, shouldn’t they invest in that mutual fund or combination of funds that promises (to them) the maximum chances of return?
I think the data that exists in India so far simply doesn’t show this to be true for index funds. If you can show me data (India specific) that shows that Index funds have beaten active funds in the past 10 or 15 years I’d see where you’re coming from but right now it seems to me that the theoretical argument is ignoring the data. Even in Nitin’s case I see that his data shows that 50% of funds have beaten the indices – and that to me is a good enough chance to take on an active fund.
I am unable to find a website that has Indian mutual funds performance for 10 years. MutualfundsIndia.com allows this to be done for a maximum of five years. If someone can share a website while allows you to compare mutual funds for 10 years, I am happy to do this analysis. Morningstar seems to offer this but does not have accurate data for many funds.
valueresearch.com you can compare upto 10 years
Manshu – Just one thing – if you have a 50% chance of beating the index for a 5 year horizon with active funds, how is it different from any other scenario where you have a 50% chance of winning? Maybe I can try to do a payoff calculation here (and I do regret not having data for 7 or 10 years) but a 50% chance of beating the index with an active fund ideally should not be giving you much of a positive payoff ………….. Thoughts?
In my opinion it is significantly different from any other scenario where you have a 50% chance of winning because here the other 50% doesn’t represent losing in the same way a coin toss would represent.
In this scenario when you lose you don’t lose everything, you lose the chance to beat the market. Losing could mean 1% below the market, 2% below the market, 3% below the market but highly unlikely that it’s zero.
It is actually not.
Consider a case where the index fund doubles in value 5 years. This means an annual CAGR of 14.86%.
Now consider a scenario in which A invests 100 rupees in an Index fund. His payoff (guaranteed) after 5 years in Rs. 200.
B invests 100 rupees in actively managed funds. He has a 50% chance that his fund gives 16.86% – that is it outperforms the market by 2%. But he also has a 50% chance that this fund may under perform the market by 2%, giving a net annual return of 14.86%. His payoff in the outperform case is Rs. 217.37 while in the case his fund underperforms, his payoff is 182.61. His “expected payoff” is thus 0.5*(217.27) + 0.5*(182.61) which is 199.99.
If you consider that he will do better or worse than the market by 1%, his payoff is actually 198.
Please do not consider this as an argument. This is just a friendly discussion. I would also expect that payoff to decrease over longer periods of 10 years ……Also consider that most active funds benchmark themselves against the index, not the “total returns” which by itself will give you 1.5% (roughly) more than the simple index. SO if a fund outperforms the index by 1.5% points, you will think its a star but actually its just accounting for performance post dividends which makes it not such a great performer.
I appreciate the discussion Nitin and I hope I’m not coming across as argumentative here either 🙂
I must admit that I was lost in your calculation and unable to see the value in this right now. Perhaps a few more years with different results will change my mind.
Hi Nitin,
Just like Manshu said, Can you present this whatever you have written in some other way !! Diff. to understand, may be you have more clarity here.
Yes Manshu, this is what I too meant.
Thanks for your reply!
Manhsu,
Very well written.Index funds have been in India for long time but haven’t found enough takers due to the reason highlighted by you. This inspite of international players with lot of experience in index fund internationally.
Hopefully, things going difficult for AMCs, some attention will shift towards these funds also and you might see bit of restructuring.
Or we could just hope that there are a handful of funds who are able to beat the market always 😉
excellent article. Even though these funds have outperformed index funds, there is always fund manager risk in an active MF, also whether the majority of active funds will still continue to outperform in the next decade is anybody’s guess!!
I think I’ve seen this reason mentioned at least once earlier where someone said that he invested in index funds so as to have peace of mind that the fund manager can’t screw up things. You’re saying the same thing right?
Very interesting topic and post with useful links.
Link of HDFC prudence pointing to Goldman Sachs Nifty BeES.
Thanks for pointing that out – will correct it later on.
Eye-opener that even Balanced funds are doing better than GS Nifty BeES. Thanks, again.
Thanks Ashok! Hey BTW did you ever invest in those international funds? How are they doing?
Hi Manshu,
Nope, not yet.