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Failed to Replicate

To replicate an index, the manager has to own stocks in the same proportion as their weights in the index

The active versus passive debate in investing started almost 50 years ago when the Efficient Markets Hypothesis (EMH) was unveiled. To cut a long argument short, the more efficient the market, the more difficult it is to generate returns in excess of a broad index.

The passive investor who believes in EMH ensures the default market return by investing in the index over the long term to cancel out volatility. The active investor tries to beat the market by creating a stock portfolio and timing entries and exits to coincide with ups and downs.

It's tempting to be active because no market is perfectly efficient. There will always be imperfections that a smart investor may exploit. But few people beat the market and even fewer do it consistently. That evidence is strongly in favour of the EMH.

When it comes to mutual funds, the entire class of index funds was created with passive investors in mind. The active investor will prefer to look at actively-managed Diversified Equity (DE) funds, which may beat the market.

However, even if you aren't a fanatical believer in the EMH, it makes sense to put at least some part of your corpus into index instruments. These offer stability to returns. You can try for an upside by also buying DE funds or creating your own stock portfolio.

The mandate for an index fund is simple: mirror the index. The fund manager has to own index stocks in exactly the same ratios as their weights in the index. If there's a change in the index population or in weights, the fund must rebalance.

Stock indices are either un-weighted, or weighted according to some formula of market capitalisation. There are two popular methods of weighting according to market cap. The simple ‘full float’ is used by the NSE-50, the S&P Nifty. In this, the market cap of all 50 constituent stocks is summed. The percentage share of an individual stock is assigned as its weight.

Whatever the method, rebalancing weights of an index fund with no change in population, is a mechanical task of maintaining even-number ratios. It's more delicate if there is a split or a new company is inducted. The fund receives dividends (the dividend yield of the Nifty and Sensex is usually between 1.5-2.5%) and that helps to cover brokerage. Index fund investors need to look at three key measures of fund performance. One is low-cost. The second is liquidity. The third is the deviation of the index fund's return from the actual index return.

The first and second measures are driven by competition. An investor can for example, create a ‘no-load’ personal portfolio of index stocks. So an index fund must be low-load and low expense ratio. Since there are many competing index funds, they all offer reasonable liquidity and reasonable expenses. The third measure is the ‘tracking error’ (TE) and this must be minimised. An ideal index fund would offer zero tracking error and mirror index return exactly. While this is obviously impossible, a good index fund will keep TE below 0.5%.

Tracking errors are understandable when there are big changes in index population. They are also normal in the first few months of an NFO. They can also be caused by a scenario of massive redemptions or by an influx of cash if new units are being issued.

In a normal scenario where there have not been big changes in the index population, an established fund should be able to minimise the TE. Surprisingly very few of the Indian index funds have been able to perform this task.

Benchmark is the only Indian AMC that is totally focussed on passive investing and it has been successful at delivering to the mandate. It offers index ETFs that all have TEs of less than 0.5%. Among the other AMCs, many have month-on-month TEs of over 3% and very few have stayed under the 0.5% threshold.

Errors of 2-3% level are not trivial due to the compounding effect and the fact that index fund investors are generally long-term players. For example, an investor with a 3% annual TE and a 3-year investment timeframe may see absolute return deviate by 15% from the index return.

Why has this happened with well-established fund houses? We see two persistent problems with portfolios of high TE funds. The first is that there are some differences in their portfolio-weights, compared to the index-weights. The second is a higher level of cash assets than desirable.

The portfolios weights are generally not very different from the index weights. But even small changes can cause relatively large TE. Stock prices fluctuate randomly and hence, stocks contribute unevenly to index-movements. If a fund is slightly overweight in the high-beta elements of the index, the TE could be disproportionate.

The second cause for deviation is easier to understand. Apart from Birla Sun Life, which has a massive 25% in cash, there are several others (ICICI and Magnum) with double-digit cash. Most index funds hold around 3% in cash. For an open-ended fund, this is not an unusual cash-level because of redemption contingencies as well as possible inflows from the issue of new units. But even 3% cash seems enough to guarantee significant TE. In effect, the fund holds an extra high-weight asset in addition to its stocks. Just 10 stocks in the Nifty and 13 in the Sensex have weights in excess of 3%.

The Benchmark schemes generally have between 0.5-1.5% of assets in cash and they appear to have gained from a structural advantage of ETFs over open-ended funds. Benchmark offers the only ETFs, while the other index funds are all open-ended. ETFs need not worry about cash redemption. Units are traded on the exchange and if at all, units are extinguished, underlying shares are offered in exchange, rather than cash. The price of an ETF may therefore, differ significantly from the actual index both at purchase, as well as at sale.

Chances are, once volumes build up, the transactional difficulties in ETFs will ease. Index funds will also gain from greater volumes because the percentage of cash held will tend to reduce as corpus rises.

However, till such time as this happens, passive investors need to be aware that the returns from index investing may differ very considerably from the theoretical return that they are counting on getting.