Index Funds don’t make sense right now

Indexing is yet to make inroads as far as India’s mutual funds industry is concerned. Though, in 2001 and till now this year, at least ...

Indexing is yet to make inroads as far as India’s mutual funds industry is concerned. Though, in 2001 and till now this year, at least 10 new index funds have been launched, taking the total number of such funds to 14, the total funds managed by them was a mere Rs 649 crore as on July 31, 2002.

Index fund replicates its portfolio in the same proportion as the components of a broad-based share index. The performance of a fund consisting of company shares weighted in this way will mirror that of the index, thus ensuring that an index fund will not perform worse (or better) than the market as a whole. Many investors have reason to favour index funds on the assumption that trying to beat market-averages over the long run is futile, and their investments in these funds will atleast keep up with the market.

As these funds track stock market indices instead of attempting to choose shares which may outperform, they simply buy all the shares in a given index. An index fund can be managed by a robot. The managers program a computer to buy the required number of shares in the required underlying stocks in the proportion of the index and allocate them to the fund.

Case against Indexing:

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Index funds have relevance in some markets.The evidence is that the more mature the market, the more difficult it is to add value for a fund manger. As in a mature market the information received by fund managers is largely the same for everybody. So without taking big sector or stock bets, most fund managers generally under-perform the index.

Since an index fund tracks a particular index, it replicates the constituents with precisely the same weightage as in the index. This means that an index fund will be as good as the index it tracks, except for the cost of managing the index fund, which leads to a marginal variation in returns. This is also known as tracking error. An index fund is passively managed since it does not attempt to beat the stated benchmark.

What are Index Funds?
They are equity funds that make investments by tracking an index. So, an index fund that is based on the sensex, will invest its portfolio in various stocks that comprise the sensex, and in exactly the same proportion as their weight in the sensex. If Infosys’ share has a weight of 20 per cent in a particular technology shares index, then the technology index fund will invest exactly 20 per cent of its portfolio in Infosys shares.

This is another constraint to Indexing in India. An Index is designed to represent all sectors of the publicly traded stock universe. Hence, even if a sector is fundamentally uncompetitive in our economy, it will find a place in the Index. But since many industries in India are fundamentally uncompetitive, why buy into a fund that perforce just has to invest in these companies?

Another reason why Index funds do not make too much sense is that our market in recent years has been narrowly driven by few sectors. So it makes sense to invest in diversified mutual funds where the job of active fund managers is to spot precisely the high-performing sectors. Besides, there has been absence of credible and truly representative index till recently.

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Yes, there could be strong case for Indexing, as our market gains maturity with increasing institutionalisation and gain sophistication for Indexing to becomes relevant. Till then we should continue our hunt for the disciplined fund manager.

The writer is the chief executive of ValueResearch, a leading provider of mutual fund data, analysis and opinion in India.

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