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Index investing yet to take off

Index investing has to wait till the active funds get tired of beating the index with a wide margin year after year. For now, Index remains what it was suppose to be- a rough pointer to the market direction

It is the goal of the fund manager--the person who decides the investments that a mutual fund makes--to beat the index that his fund is compared to. That is what a fund manager is paid for. However, there's a certain type of fund--index funds--where the goal is to not beat but exactly match the index. Managing such a fund requires no research and no active fund management since all that needs to be done is to mechanically match the shares that the fund holds to the ones that make up the index. Since index funds do not have to pay for research and fund management, they charge investors much less than actively managed funds.

It is often said--although I don't know this for a fact--that in America, index funds do better than most funds. This is said to be a sign of an efficient market--one where all information about stocks and future expectations are generally the same between various market participants. An argument is often made in the US that since actively--managed funds, on an average, do not beat the indices there's no point in paying their higher charges. Cheap and efficient index funds, goes the logic, ought to be fine for anyone.

In India, index investing hasn't really taken off. Investors have great belief in active management and I think the kind of person who's attracted to the stock market in India doesn't find the idea of index funds exciting. Indian index funds have just Rs 1,330 crore invested in them out of a total of about Rs 83,000 crore for all equity funds.

However in the last few weeks I've run into a number of people who've claimed that things are changing and the average Indian fund is no longer able to beat the index. My normal answer to this is always to tell the other person to not invest in an average fund and come to Value Research website and locate those which are much better than average. Still, so many people have been talking about this that I decided to take a hard look at the numbers, and found no surprises at all.

When the markets fell in May, June and July, most funds fell more than the Sensex and the Nifty. However, I find this irrelevant because apart from odd periods like this, a majority of actively managed Indian funds appear to find it easy to beat the big indices. Right now, when you consider data for the last five calendar years, the Sensex was beaten by 46 per cent of the funds in 2001, 92 per cent in 2002, 94 per cent in 2003, 96 per cent in 2004 and 58 per cent in 2005. The corresponding numbers for the Nifty are 42 per cent, 94 per cent, 94 per cent, 99 per cent and 83 per cent.

Looking at the entire period as a single stretch, I find that over the last five years, the Sensex, when compared to all equity diversified funds, would have earned a rank of 52 out of 55 and the Nifty--hold your breath--55 out of 55. That means that a Sensex index fund would have beaten only the three most deadbeat actively managed funds in India (Taurus Discovery, LIC Equity and UTI Brand Value, in case you are curious to know), and a Nifty index fund wouldn't have managed even that.

Of course, this is not to say that there is something wrong with these indices. They are meant to be benchmarks of the markets and that's a job they do well. Just don't expect them to be great investment portfolios.

Index investing may start making sense in this country one day, but that day certainly isn't here yet.