Index Laggards

Not all funds are able to beat their benchmarks even in a bull market. Here are the laggards among the equity diversified schemes. Analysis by ML Research Desk

Mutual funds are flocking to the market with New Fund Offerings and collecting money by the fistfuls from retail investors who think that this is the best route to be a part of the stock market boom. In a bull market, equity funds...

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  • Investing Abroad? wait!

    Fund companies are offering a chance for geographical diversification.

    India now attracts the whole world's attention. From direct investors who put money in Indian business operations to financial investors who buy Indian equities, foreign institutional investors are scouring India for opportunities. India is now mentioned in the same breath as China because India now offers both domestic business opportunities and skills to grab export opportunities. The Indian market has gone up 100% in two years pulling Indian mutual funds out of a decade of pathetic performances. Attracted by this, Indian savings are moving into Indian mutual funds which are recording massive collections. In a situation like this, in the last budget the Finance Minister raised the ceiling on aggregate investment by mutual funds in overseas instruments from $1 billion to $2 billion. More importantly, the government has decided to remove the silly requirement of 10% reciprocal shareholding for investment abroad. Under that rule, a domestic fund could invest in the stocks of only those foreign companies, which have a listed Indian subsidiary with at least a 10% share holding in it.

    When India is a hot destination for the rest of the world, why would you put your money anywhere else? Well, the government of India, in its wisdom has allowed this and Franklin Templeton has been first off the mark to seize this opportunity. Should you bite? Theoretically, there is a case for investing outside the home country, especially when it seems that for a variety of long-term reasons, the domestic economy will not do too well. Companies may be trapped in structural problems of the macro economy (as in the case of African countries or India of the mid-90s or Germany and France now) and therefore investors would be better off investing in countries where entrepreneurial activity is far more rewarding.

    But that is theoretical. It can be nobody's case that enterprise is not rewarding in India. Certainly not now. There is an upsurge of activity in India and for the first time ever, all sectors are booming at the same time, in a self-reinforcing manner.
    There is a second reason to put your money abroad and that is valuation. It could well be that a certain market today is in the same state as India was in 2003 and it may make sense to get in there. Unfortunately, this too does not apply. From Japan to Kuwait and from New Zealand to Brazil, markets are making multi-year highs everywhere. It would have to be sheer wizardry to be able to discover undervalued opportunities in other parts of the world. Here are some reasons to avoid this fund now:

    The fund would be invested in either another country funds or stocks. How much do you know about them? Domestic investments are something we understand best. There is nothing you know about Brazil's Companhia Vale do Rio Doce or Korea's Korea Telecom.

    Track record
    It is not clear whether Templeton India's fund managers would be the ones ultimately picking the global stocks and on what basis. Templeton is a global organisation with varying investment styles. They track the global economy, various countries and markets. This can be a hindrance or an advantage. After all, Templeton's domestic performance under the emerging markets guru Dr. Mark Mobius was quite pathetic before Templeton India bought Pioneer and the fund management team from Pioneer took charge. {break}

    Funds that put your money in other countries offer another round of diversification. The question is: do you need it? We don't see how you can derive additional returns without reducing risk. After all, understanding the risk profile of companies and funds is tricky enough. Understanding the risk-profile of countries is nearly impossible.

    Leaving aside the risk aspect for the moment, where are the returns? The US markets which are the biggest, the busiest and among the most transparent have been poor performers. Indeed, it could well be that a fund reduces your return when it invests in a different country. The S&P 500 went up just 11% in the last 12 months. Markets of Germany, Japan and Canada are up between 25%-40% - much lower than India and Brazil.

    Every year some international market will perform supperbly But many of these markets are just too volatile. In the first five months of 2004, the China Fund, listed in the US lost 50% of its value. Between 2001 and 2002, the Canada Index lost 60% of its value and from March of 2000 to October of 2003, the German index dropped 73%.

    If you must invest…
    It will be necessary to monitor whether the fund has a strategy of geographical diversification. A fund that follows the latest fad and invests in geographies that are currently doing well can be leading you into a high-risk zone. While raising money a fund can say several things as a matter of strategy but what it actually does is another matter. This needs to be monitored. It would be great if money is spread over key economic regions. In fact, when investing internationally, a fund has a huge menu to pick from. It can choose not only from fast-growing countries but stocks that are growing fast in an otherwise slow-growing region. It can buy regional funds or indices that spread their investments across a whole region. It can spread its money between momentum and value-based countries and sectors. The question is why would you want to your money to do any of all this? Because you trust your fund manager blindly?  That is not a very sound argument.

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    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.

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    1 month 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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