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Index Funds and ETFs – another Investment avenue

Index Funds

In the world of investments an investor has to walk on a tight rope balancing between risk and return. Amid decline in the savings bank rates, investors are forced to look at other alternate assets to park their savings to generate that extra return to shield from inflation. Among the alternatives equity is the first asset class any investor come across due to its attractive features like long track record of superior returns, convenience of entry and exit with-out any lock-in period, lower ticket size, lower transaction cost and lower tax on capital gains, however, many investors are pulled back by the perception of high risk associated with equity investments.
Within equity investments, Index funds and ETF (Exchange Traded Funds) are gaining more popularity among the investors who choose to take lower risk.

Index Fund is a passively managed fund, which replicates all the stocks/bonds of an index in the exact proportion. As these are passively managed funds, fund manager is limited only to the extent of mirroring the index. Hence the costs will be low. However sometimes Fund Manager lags in the performance of the fund vis-à-vis index. The difference is called Tracking Error.

Index funds and ETFs are gaining popularity in India, as these funds have managed to perform better than some of the actively managed funds in the last one year. This was due to the stellar performance of the few heavyweight stocks in the index, while there was a muted performance in the broader market, due to general slowdown in the economic growth as well as tight liquidity conditions in the credit markets which affected large number of companies. At the same time lower expense ratio of Index funds and ETFs also helped to edge some of the actively managed funds.

With regard to actively managed funds, the performance of these funds got affected, due to changes in SEBI regulations with regard to re-categorization of funds, and also changes in benchmarking mechanism. Earlier, mutual funds used to bench mark their performance to index, but now they have to bench mark it to TOTAL RETURN INDEX, which will make the job of the fund manager more difficult to generate alpha in short term.

However, SEBI has also reduced the TOTAL EXPENSE RATIO considerably, which makes the actively managed funds more attractive and the investors due to lower expense ratio will make decent superior returns. The schemes with larger AUM will become more attractive for investors, because the impact of reduced TER will help in generating decent alpha over index in longer period.

Majority of the actively managed mutual funds generally don’t replicate the index, instead they take Index as benchmark and try to outperform it. As the fund manager does research to decide whether to buy or sell the stock and time the entry and exit, the expenses of the fund increases. Fund manager analyses the potential risk-return profile before taking any call. The additional gains of the mutual fund manager generates over and above the benchmark index return is called Alpha. Fund manager works towards protecting the fund from any major losses when the markets are volatile and also take a call on profit booking based on the potential upside in the stock as well as market.

Index Funds could generate superior returns than the actively managed funds in short time, but in general the actively managed funds has the potential to perform better in emerging markets like India.

In India majority of the Index funds and ETFs primarily focus on the frontline indexes like Nifty, Nifty Next50, Nifty 100, SENSEX etc which are also benchmarked by large cap mutual funds hence as per the mandate they are unable to invest in the mid and small cap companies. Actively managed funds like multi-cap funds and mid-small cap funds on the other hand can invest in these mid and small cap stocks to participate in the broader growth of the market and hence has the potential to generate superior returns than index funds and ETFs in long run.

In emerging markets like India, equity markets are not as efficient as they are in developed economies like the US. At the same time equities as an asset class is expected to attract increased inflows in the coming months as globally interest rates are not expected to rise in the medium term. Foreign fund Inflows into emerging markets, especially into Indian equity markets are expected to be on a buoyant note.So it is possible for the fund managers to actively participate in the market through stock selection as well as entry and exit decisions, to generate superior alpha over index funds.

India is on course to double the economy in the next few years, considering the expectations over a reasonably stable coalition government formation after the general elections 2019, course correction measures taken to tackle the distress in the rural and SME sectors could bear fruits in the coming days, while lower interest rates, stable crude oil price and INR could support for macroeconomic stability, and size of the opportunity and local knowledge of the mutual fund managers it could be possible for generating superior alpha in the actively managed mutual funds in the coming years.

At the same time, index funds and ETFs could be preferred during times of higher volatility and also for capturing short term market fluctuations. However in the long term, considering the larger growth prospects in India actively managed funds could provide a wide range of alpha generating opportunities at various risk-reward profiles.

Advantages of Index Funds:

• The expense ratio is very low
• As the fund replicates index, investor gets the diversification benefit of that index follows
• Biased or emotional selection of stock by fund manager is eliminated
• Index funds are very transparent in terms of stock investments

Disadvantages of Index funds:

• Stock selection is not possible.
• As the fund mimics an index, fund manager will not be able to generate alpha.
• These funds are not downside protected i.e., in case of bad news in a particular stock, fund manager cannot exit that stock.

ETF is a fund which is traded on the stock exchanges. These funds are constructed by tracking a specific index and replicate the stocks/bonds of index in same weights. These funds are available at a low cost.

Advantages of ETFs:

• Available at low cost
• Trading is flexible as ETFs are traded like stocks hence buying & selling on same day is possible
• ETFs are transparent

Disadvantages of ETF:

• The trading volumes of ETFs could be low at times hence may not offer high liquidity

Return of Index Funds

Fund Name 6Months 1year 3years 5years
UTI Nifty Index Fund 13.35 10.51 15.45 12.89
HDFC Index Fund – Nifty 50 plan 13.34 10.35 15.35 12.88
ICICI Pru Next 50 Index Fund 4.51 -9.27 13.35 15.36
Aditya Birla SL Nifty ETF 13.12 10.33 15.59 13.13
ICICI Pru NIFTY 50 ETF 13.45 10.73 15.75 13.18

Return of Large and Multi cap Funds

Fund Name 6Months 1year 3years 5years
Reliance Large Cap Fund 10.71 8.24 16.90 16.82
HDFC Top 100 Fund 11.47 11.62 16.56 14.39
Axis Blue chip Fund 14.38 9.38 15.25 14.62
Mirae Asset Large Cap Fund 11.44 8.53 17.33 18.21
Aditya Birla SL Equity Fund 8.72 -0.64 14.92 17.26

As on 1st May 2019. Source : Value Research


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