Last few months there is a lot of demand for index investing via index funds and index ETFs. Why is this sudden interest in these index type funds?

If you look at the AMFI data, there is surely a wave of interest building up in index funds and in index ETFs. Index Funds are big business in other parts of the world but in India they have hardly taken off. There were several reasons for the same. In India, the opportunities for alpha are so many that fund managers hardly found the need to push index funds as an asset class. For example, in a country like India nearly 80% of the fund managers outperform the index whereas in other countries it is less than 20%. So, if you invest in equity funds with reasonable level of due diligence, then you stand a very high chance of outperforming the market. But all that is changing in the last couple of years. Index funds offer market type performance with very limited market risk and can be a good form of passive investing.

Let me share with you some of the key benefits of index fund investing or index ETF investing and why you can look at that as a separate investment class.

· An index fund will not outperform the index, but will be on par with the index. As we saw earlier, that is not really bad. It can still promise you good returns over a longer time horizon. The Sensex has a base value of 100 in 1981 and over the last 39 years it has given 38-fold returns. The Nifty has its base in the year 1995 and has given 11.50-fold returns over the last 23 years. That means you can get the benefit of equities via an index fund without taking on too much of stock specific risk.

· The big advantage of Index funds is that it overcomes the bias of fund manager discretion. Fund managers are humans after all and so human discretion is part of their job. That is the problem with most diversified equity funds. There is a strong element of discretion that is available to the fund manager. As a result, the fund manager’s conditioning, biases, preferences, predilections and past experiences influence the investment strategy of the fund in a very big way. The index fund, being a passive fund, has no room for such biases.

· The big advantage could be the cost factor. Costs in an index fund are substantially lower. For example, an index fund would have a TER of around 1.2% while the equity diversified fund will have a TER of 2.5%. This makes a huge difference over the longer time frame. In the 2017 annual general meeting of Berkshire Hathaway, Warren Buffett had lauded the efforts of John Bogle, the founder of Vanguard Funds. Vanguard is one of the world’s largest asset managers with over $4.50 trillion in AUM. Buffett pointed out that Vanguard saved billions of dollars in costs to mutual fund investors by adopting an index based strategy, which is a lower-cost strategy.

· Index funds are more transparent in their intent. Many diversified funds are actually index funds with minor tweaks since a major proportion of their portfolio is invested in index heavyweights. Therefore, you end up paying a higher Total Expense Ratio (TER) for marginal return benefits. Index funds help you to overcome this challenge. In India, Index funds have actually performed reasonably well if you consider their returns net of total expense ratio (TER) costs.

· As alpha gets harder to generate in the Indian markets, there will be a greater onus on index funds for their passive approach. Why pay high fees to active managers when the additional returns are not justified. Once the index methodology becomes tighter and information flow more efficient, the returns differential between active funds and passive funds will reduce to a much lower spread.

But there are likely to be some key challenges for index funds in India

There are certainly some downsides to index funds too! For example, active investing works better when market are too volatile. In such cases the active manager can increase the cash holdings temporarily. Secondly, index funds are vulnerable to the risk of tracking error. It is the extent to which the index fund does not track the index and in India such tracking error can come from frequent changes to the index or from chasing alpha even in the case of index funds. Index funds have not been great performers in the past, but as the alpha gets harder to come by investors will realize the importance of these index funds and index ETFs. Index Funds and index ETFs may not yet have caught on in India in a big way but it surely an idea that is likely to bigger in the days to come.