Buying Index Funds? Look at the Costs

Index funds are supposed to be cheap. But they are not. That is the best reason to avoid them

Index funds do not attempt to actively trade stocks. They try to track the averages, not beat them, by buying and holding the securities in their benchmark indices. An index fund mirrored on Sensex will buy 30 Sensex stocks in the same weight as the index. Just by doing this, index funds manage to beat many growth funds even though these funds put enormous resources into stock picking (and market timing). Indeed, as our cover story last time pointed out, just by holding the 30 Sensex stocks in proportion to their weights, you would have outperformed at least half of the diversified funds benchmarked to the Sensex and equalled the average return of all diversified funds put together. And all this, without any special skills, money and research. The longer the duration the better is the performance of index funds.

What if you bought index funds in the last 12 months? Look at a sample of index funds that are benchmarked to the Sensex. You would have made at least 50% and at most 70%. That would have easily equalled the average of diversified funds benchmarked against the Sensex, which was 70%.

The question is if index funds aim to offer only average returns, why are they able to beat the most actively managed funds over the long term and sometimes even over the short term? The answer is lower costs. Since index funds do not have to spend money on researching stocks or on trading, they can eliminate huge costs of research and brokerage commissions. So, their average return before expenses turns into above-average return after expenses. The expense ratio of an actively managed fund in the US is about 1.5%. Index funds can have an expense ratio of 0.2%. Also, since index funds buy and hold securities for as long as they are in the index, they avoid trading and pay lower taxes. Many US funds have a turnover or churn of 85% per year. The transaction costs on the account eats up another 0.7% of return.

Taking into account expenses and trading costs, an index fund has a performance advantage of about 2 percentage points a year. As it is, it is quite hard for a stock picker to beat the market. But to outperform it by more than 2 percentage points a year is extremely tough. That's why it is rare.

So, should you go out and buy index funds? Unfortunately, the Indian fund industry has sabotaged the whole concept of index funds by making them abnormally expensive. Consider this startling fact. Just to buy and hold the same securities in Nifty and Sensex where no research is involved, index funds in India are charging the same level of fees as a actively managed growth funds.

Index funds in the US charge around 0.10-0.20% of net assets as fees. Fidelity has contractually limited Fidelity Spartan 500 Index's total annual fund operating expenses (not including interest, taxes, brokerage, securities lending fees, or extraordinary expenses), to just 0.10%. Expenses simply cannot go beyond this level. By contrast, index funds in India are just too expensive. Franklin Templeton Sensex has an expense ratio of 1%. HDFC Sensex's expense ratio, strangely, is 1.50%. {break}

And what do you get by way of performance? A slight edge over the market average at times. We took the sample of index funds that are benchmarked to Sensex. To buy and hold 30 stocks in the same weight as Sensex they charge you around 1% per year.

It is a huge irony that index funds should be so expensive. The main reason index funds came into existence was costs. In 1975, John Bogle presented an idea to the board of directors of the newly formed Vanguard Group. He suggested the creation of an extremely low-cost mutual fund that would not attempt to beat the returns of the stock market as measured by the S&P 500 index. It would simply attempt to mirror the index as closely as it could by buying each of the index's 500 stocks in amounts equal to the weighting within the index. In his account of The First Index Fund, Bogle writes: "I projected the costs of managing an index fund to be 0.3% per year in operating expenses and 0.2% per year in transaction costs. Since fund annual costs at that time appeared to be about 2.0%, I concluded that an index fund should reasonably be expected to provide an annual return of +1.5% above a managed fund."

Well, the actual gap between the market average and the average of actively managed funds has been significantly wider than the 1.5% that Bogle anticipated. In the 1990s, the total shortfall between actively managed mutual funds and the market as measured by the S&P 500 has  been a huge 3.4% per year.

The difference between actively managed funds and passively managed index funds can be explained very easily. It is not that actively managed mutual funds are run by idiots. Bogle estimates that the difference is determined by four factors: costs, turnover, sector, and cash reserves. Of these costs is the most important.
During the 1990s, the S&P 500 has yielded an annualised return of 17.3%, compared with just 13.9% for the average diversified mutual fund. What was the role of costs in this? The expense ratio of the average fund was about 1.3% during the period. By comparison, the Vanguard S&P 500 expense ratio is 0.19%.

As long as index funds in India do not bring down their fees to much lower level, simply avoid these. Remember index funds have no edge as long as the costs are so high. The other way to take advantage of the benefits of indexing is to go for Exchange Trade Funds (ETFs). ETFs are hugely popular in the US as they offer an even lower cost alternative to index funds. Unfortunately, ETFs have not been marketed well here, despite being far superior to index funds in a variety of ways.

2 years ago
Hi sir, Thank you for your valuable article. NOW (22-4-2020) the expense ratio of index fund is available at 0.1 % ( UTI Index fund-Direct) is it worth to go with index funds?
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