Index funds suddenly in favour, but will they be run with greater accountability?  

April 21, 2010

 Index funds seem to be in vogue nowadays. Fund houses are suddenly launching index funds with vigour. IDFC Mutual Fund recently announced the launch of a new scheme IDFC Nifty, benchmarked to the Nifty. IDBI Mutual Fund is awaiting approval for its index fund product from the Securities and Exchange Board of India (SEBI). Motilal Oswal AMC is bringing out a flavoured index product.

This sudden clamour to launch index funds marks a drastic shift from the normal indifference to this superb investment product meant for the masses. Index funds have barely found a space inside the conscience of the average investor here. The response to previously launched funds has been lukewarm at best. Indeed, the total assets under management (AUM) in index funds are a miniscule Rs1,204 crore, including growth and dividend schemes.

An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the S&P CNX Nifty. Investing in an index fund is a form of passive investing. There is no active stock picking involved.

There are various reasons why index funds have failed to take off in this country. Fund companies were earlier reluctant to sell index funds as they considered themselves smarter than the overall market. It was probably beneath them to consider offering a product that only sought to mimic the returns given by the broader markets. The performance of most actively managed equity funds shows, however, that this feeling of superiority is a highly misplaced one.

Another reason why index funds are not so popular is that not all such funds are actually purely passive in nature. Most fund managers try to beat the benchmark index by tweaking the underlying portfolio of the index. Not only does this defeat the very purpose of an index fund, it leads to substantial underperformance relative to the benchmark.

It is this practice of actively managing a passive product that gets index funds into trouble. Funds try their hands at ‘enhanced indexing’ by adapting the actual index (constituents forming a part of the index) underlying the fund as per their whims and fancies. The result—a huge tracking error that puts off investors.

LIC Mutual Fund has a notorious track record when it comes to tracking error. Over the five-year period, three of its funds feature at the bottom of the table comparing their performance to their respective benchmarks. LIC MF Index Fund-Sensex Advantage Plan has an unforgivably high tracking error of 9%, followed by the LIC MF Index Fund-Nifty Plan and LIC MF Index Fund-Sensex Plan, with tracking errors of 7% and 5% respectively. HDFC Index Fund linked to the Nifty and Sensex too run a high tracking error of 3%.

In such a scenario, why would investors want to part with their money when several index funds cannot even manage to mimic the index performance? Investors in these funds only wish to participate in the stock markets without having to deal with the inherent volatility. But the way index funds are managed, most investors don’t get what they have paid for.

— Sanket Dhanorkar