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The sorry state of Indian index funds

Index funds and ETFs have remained a non-starter in India. A number of reasons are responsible for this

The sorry state of Indian index funds

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When ETFs and index funds are the rage all over the world, why haven't they taken off in India? According to AMFI data, the ETFs in India (excluding gold funds) manage just 3 per cent of the total assets in the fund industry.

This active-fund bias is attributed to sheer ignorance. Indian investors, experts reckon, are simpletons and thus don't analyse active-fund performance on the basis of total returns, survivorship bias, alpha and other esoteric variables before concluding that they are better.

But in reality, there's a far simpler explanation of why Indian investors shy away from index investing.

Tracking error
Index funds and ETFs in India show quite a significant deviation from their benchmarks. A Value Research analysis of 67 (non-gold) index funds and ETFs showed that on one-year returns, 45 per cent of the schemes showed a 1 per cent or higher annual deviation from their benchmark returns. On a three-year basis, 30 per cent of the schemes generated returns that were 1 per cent or more off from their chosen benchmarks. On a five-year basis, 25 per cent of the funds showed a 1 per cent return differential. Over a ten-year period, 19 per cent of the funds registered this deviation. This analysis is based on data as of April 19, 2017.

Some passive schemes strayed off course by a mile. But the above data may not seem alarming to investors because in most cases this tracking error is positive. That is, most of the index funds and ETFs that featured high tracking errors recorded returns that were higher than those of the index.

That's a good thing, isn't it? Well, it isn't, because the mandate of an index fund is to stick to its chosen benchmark like a second skin. It has no business either underperforming or outperforming its chosen index as that could indicate higher risk taking.

The 'outperformance' in most of the above cases seems to come from the fact that most index funds and ETFs benchmark themselves to the plain-vanilla price indices and not to the total-returns indices of their chosen benchmarks. Thus the index fund receives dividends from its portfolio companies, but that doesn't get reflected in its benchmark, making the fund's performance look better.

To get a truthful picture of index-fund performance, therefore, the investor should measure its returns against the total-returns index. But as the exchanges in India provide data on the total returns of a very few of their index products, the lay investor will find it quite difficult to make this comparison.

Not cheap
A second argument for passive investing in the global context is that index funds charge a fraction of the costs that active managers do. In India, this doesn't hold true for most index funds.

True, with the emergence of more index products, you now have a few ETFs that charge less than 0.10 per cent of the NAV as annual expenses. But then, there are a good number of index funds that charge you more than 1 per cent, too. Our analysis showed that 12 of those 67 index schemes had an annual expense ratio of over 1 per cent as per their latest factsheet disclosure.

This is less than what active funds charge (2.5 to 3 per cent). But a management fee amounting to 1 per cent is still too high for a product that requires zero stock selection or active calls.
Fees apart, as ETFs can only be bought or sold through the exchange platform, you will typically pay brokerage as well as securities transaction tax. This apart, thanks to the thin and often erratic trading volumes on many ETFs in India, traded prices of ETFs are sometimes at significant premiums or discounts to the fund's NAV. Such distortions are quite common for ETFs tracking sector or thematic indices. In fact, the trading volumes in such ETFs may sometimes be so thin that you may not be able to enter or exit the investment at a time and price of your choice.

Wrong indices
Finally, faithfully mimicking an index makes sense only if the basket of companies that make up the index have good fundamental prospects and are potential long-term wealth creators. But most of the available index products in India don't put much science into the index they track. They end up passively mirroring the market bellwethers such as the Sensex or the Nifty. In our analysis, 37 of the 67 index funds in operation piggybacked the Nifty or the Sensex, with a majority of the others tracking readymade sector indices. However, we all know that the Sensex and Nifty baskets comprise the most active and liquid names in the market. These are not necessarily the best fundamental bets.

Three requirements
All this suggests that for passive investing to really take off in India, we need three factors in place. One, we need better indices constructed specifically with long-term investors in mind. A total-market index or a fundamentally constructed index may present a far-worthier basket for index investors to mimic than the Sensex or the Nifty. A few such ETFs have made a tentative debut in recent times and track the Value, Quality, Dividend Opportunities and other thematic indices put out by the stock exchanges. But with a very limited track record on these indices, this remains a very nascent space.

Two, index funds need to be far more efficient at tracking their chosen benchmarks than they are today.

Three, along with beefing up their efficiency, AMCs also need to ruthlessly prune their costs on index funds.

Maybe indexing in India will undergo this transformation only if global indexing specialists, like Vanguard, enter the Indian market. After all, for AMCs, which manage a large portfolio of active funds, along with a few ETFs/index funds, there's little incentive to promote the latter.