But, while the high utility of index funds is an accepted theory in the United States, does it really work in developing economies like India? There are few clear advantages. One, cost. Most index funds charge less than 100 basis points, while diversified equity funds cost a lot more (200-300 bps or even more in some cases). Two, lower volatility. Given that these funds follow benchmark indices, unless the fund manager has been managing the scheme actively, there is little chance that the index will move more than a couple of percentage points either side of the index. The difference in performance between the underlying index and the fund is called tracking error.
“Index funds or ETFs are suitable for those investors who wish to avoid active risk and are looking to generate higher return compared to other asset classes. The advantage of index funds is investment in diversified portfolio with low cost,” says Krishan Kumar Daga, senior fund manager — HDFC Asset Management, adding that a lower tracking error shows that the fund is closely following the benchmark index.
However, despite these obvious advantages, many believe that there are too many opportunities for fund managers in India unlike the US. Feroze Azeez, Deputy chief executive officer, Anand Rathi Private Wealth Management says: “In India, 80-90 per cent of the funds beat the index, while in the US only 10 per cent beat the index.”
According to Kaustubh Belapurkar, director – Fund Research, Morningstar India: “In the Indian market, a fund manager provides lot of alpha over the index. In case of actively traded large-cap funds, the returns could be higher than the index by 200-300 basis points over a five-year period. While in case of mid-cap funds returns could be even higher. That is why over the long term actively adjusted funds will give better returns,’’ he says.
Data support Belapurkar’s views. Over a 10-year period, equity diversified funds have returned 10.93 to 13.91 per cent a year, whereas returns for index funds have been in the range of 7.2 to 8.79 per cent annually, according to data from Value Research.
Azeez says such funds do not pinch the pocket and if the fund manager is not very aggressive, returns can be steady over a long period as well.