Are Index ETFs appropriate for you?

Posted On Thursday, May 01, 2008

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The argument is almost as old as the markets.Would investors be better off by investing in funds that passively track an index (like the BSE Sensex or the S&P CNX Nifty) or by investing in an actively managed fund (where the fund manager takes a call on which stocks or sectors are selected for investment)


Most mutual funds available in India come under the actively managed category. Essentially this means that the scheme's fund manager and research team analyses various stocks and decides what to buy and when. The purpose of such actively managed funds is simple – beat the market; beat the benchmark; beat the index. Naturally, as actively managed funds expend a lot of time and effort in an attempt to provide superior returns, the expenses will be on the higher side.


Passively managed funds (or tracker funds) do not attempt to beat the market. They are structured to provide returns that match the market. Index funds are one of the more common passive funds. The objective is simple - Replicate the stock holdings of a broad index (BSE Sensex, S&P CNX Nifty), a sectoral index (BSE IT Index, Bank NIFTY) or a capitalization index (CNX Mid Cap, BSE Small cap) in order to mirror the returns of that particular index. In short, the basic philosophy of an index fund is that 'One cannot beat the market' and that tracking the market's performance will produce a better result compared to the other funds. Market can be an ambiguous term. Here, it refers to a widely followed benchmark like the S&P CNX Nifty or the BSE Sensex.


If you can't beat them, join them.

Proponents of Index fund investing normally quote the argument of the 'efficient market hypothesis'. The hypothesis asserts that financial markets are efficient from an information perspective. Prices of traded assets like stocks, bonds, commodities and property are believed to already reflect all known information. In short, it is impossible for investors to gain above-normal returns because all relevant information that may affect the asset's performance is already included. So, if it is not possible to beat the market, the next best thing is to replicate it.


And it's cheap too

Index funds have a natural cost advantage.Their objective is to replicate an index. So, there are no obnoxious salaries to be paid to star fund managers and research teams. The holdings of the scheme also change only when the index composition changes – which usually are few and far between. All these benefits help index funds to have lower costs in the range of 0.5 – 1.0%. In comparison, actively managed mutual funds charge in the range of 1.5 to 2.5%. The key question for investors is “Are the extra expenses worth it?” In a bull run, it may not make too much of difference. Returns are high and the expense ratios are relatively negligible. During stagnant or bearish markets, when returns are minimal or negative, low cost funds will prove their worth. Expense ratios will always be charged, irrespective of whether the markets move or not. Assuming the market has not moved at all during a year, you will still lose the 1.5-2.5% on a regular mutual fund. If you had opted for an index based fund, your losses will be lower.

The state of the economy will also impact stock market returns. Most indices are based on liquidity (number of shares traded daily),market capitalization (total value of the shares of the company), free float, or a combination of these. Naturally, most indices will be skewed towards the more popular stocks (those that have larger market capitalizations or are more frequently traded).

In a growing economy like India, mid-cap and small-cap stocks can show phenomenal returns over the long term. Unfortunately, these may not be reflected in the broader indices. (Ofcourse, there are mid-cap and small cap indices for the purpose). Index funds will also take time to adapt to sudden structural changes in the economy.

For instance, technology stocks started to boom in the late 90's. But it took some time for hese stocks to be incorporated in the mainstream indices. Index fund investors missed out. The story was repeated recently with real estate and infrastructure companies.


So, why should one invest in index funds?

As mentioned earlier, the debate continues to this day about whether index based passive funds are superior to actively managed funds.In mature markets like the U.S., it is a common statistic that a benchmark index like the S&P 500 outperforms about 80% of actively managed funds.

The worry for investors is how do they identify the 20% that will beat the index? Picking the good funds out of the plethora of choices available is almost as difficult as picking individual stocks. This leads to a never ending conundrum. Investors opt for mutual funds in order to save themselves the troubles and hassles of picking stocks. They pay professional fund managers to do it; and now they have to spend an almost equal amount of time and effort to select the most appropriate fund manager for the job.



In the shorter term or in growing and emerging markets, actively managed mutual funds are likely to outperform index funds. But in the long term and in mature markets, the expense ratios of active funds are a disadvantage – The higher costs drag down the performance and make it difficult to outperform index funds.


What do Indian investors do?

The ideal option would be to go in for a mix of active and passive managed funds. New industries and sectors are coming up in India almost every other year. If investors wait for these sectors to be included in the index, they may miss out on the early gains. Adding index funds to your portfolio would help you to get an exposure to the larger India story and also ride out bear markets at little cost.

This portfolio allocation will help investors to spread their risks and reduce the volatility of returns resulting in an increase in the performance.


What next?

Now that you know what index funds are, the critical question is 'What kind of index tracker is optimal?'

Should investors opt for mutual fund index funds or the newest option on the block – ETFs?

ETFs have grown in popularity due to their cost,size and time advantages. ETFs appeal to a large section of the investing public as they are flexible investment vehicles. Irrespective of your investment philosophy (whether you are a passive investor or an active trader), ETFs offers investors a lot of benefits.

One of the key features of ETFs is their flexibility. They can be purchased in smaller sizes. Convenience is another factor – they can be traded just like stocks on a real time basis.The trading flexibility of ETFs is unmatched by mutual funds. In the case of mutual funds,investors only get the end of day NAV (based on the closing value of the index); they are unable to benefit from intra-day movements.

Let us also take a look at which option is a better tracker of the Index? Open ended index mutual funds undergo constant rebalancing due to the daily net subscriptions or redemptions. These add to trading costs and reduce the economic viability. ETFs on the other hand have a unique process of creation and redemption in kind which helps to minimize these transaction costs. Index funds may also require additional amounts of cash as provision for daily redemptions. The extra cash again causes a tracking error. (Tracking error is the difference between the movements of the Index and the fund). ETFs do not suffer such a cash problem – another advantage of the creation / redemption process.

And of course, there is the cost advantage. Like most mutual funds in India, index mutual funds may come with entry loads. ETFs are bought and sold directly on the exchange, so you only incur a brokerage fee. Management fees and expense ratios are also lower for ETFs.

In the end, the choice comes down on to the issues of management fees, shareholder transaction costs and taxation treatments. Considering everything, ETFs emerge a clear winner.

Above article is authored by Quantum.

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