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The Lost World

Somehow, index funds, an important investment option, seem to have been bypassed by investors & fund houses

One of the ways in which the investing preferences in India are radically different from many of the first-world markets is our lack of interest in index funds. In the US, nine per cent of the money invested in mutual funds is in index funds, in India, this number is less than half a per cent, or about Rs 2,700 crore.

However, among the investing community, index funds take a mindshare that is out of all proportion to their size. The reason is that the concept of index investing is important, and so is the availability of index funds as an option for investors. Index funds are mutual funds that aim to replicate the performance of a market index. Thus, an index fund that is based on the BSE Sensex should have exactly the same 30 companies’ stocks that the Sensex has in exactly the same proportion. Thus, investors who put their money in such a fund would find their money gaining and losing in exactly the same proportion as the BSE Sensex does.

In some senses, an index fund completely reverses the main logic of mutual funds. Funds managers are supposed to provide individual investors the professional investment management that the investors don’t have the expertise for. Instead, the logic of index funds says that the fund managers themselves don’t have this expertise either and therefore, investors should simply follow the markets.

Is this true? In India, this wasn’t true till about a year back but in recent months, the performance of a majority of mutual funds is falling rapidly behind the indices. Over the last six months, barely 10 per cent of the 193-odd diversified equity funds have beaten the Sensex. This could be an anomaly of the falling market, but one thing is certain, equity funds are not beating the indices in an overwhelming way that they used to earlier.

Unlike other mutual funds, an index fund is not an investment management service at all--it’s just a convenience that enables you to buy and sell all the stocks of an index in an easy and tax-efficient manner. Since index funds do not need to do any research, fund companies should be able to charge less from investors for running them. Indeed, SEBI limits fund companies to charging 1.5 per cent a year from index fund investors, instead of the 2.25 per cent that is permissible for other equity funds.

So that means that index funds are a great investment options, right? Well, not quite. I’ve been describing the properties of ideal index funds and talking about the performance of the indices themselves (and not of index funds). However, there’s a bizarre twist to this tale. The Indian mutual fund industry seems incapable of running index funds that can actually replicate the performance of the indices they are based on. Of the 25 or so index funds that exist in India, only about 10 had returns that differed from that of their index by more than a per cent over the last year.

In fact, some index funds have had substantial variations from their indices. For example, LIC Mutual Fund’s as well as HDFC Mutual Fund’s Sensex index funds lost around 13.1 and 12.3 per cent respectively over a period during which the Sensex lost 7.7 per cent. This can hardly be described as a competent implementation of the index fund concept. This is not to say that all index funds are like this. There are many that track the indices much better. However, this variability brings an unwelcome element of complexity to choosing an index fund. Index funds of a type called Exchange Traded Funds (ETFs) are more capable of tracking the indices accurately. These are traded like shares and have to be bought from a stock broker.

With time, I expect index investing to become more and more relevant to investors. I just hope there are a range of well-run index funds to choose from.