Why Index Funds Don’t Make Much Sense

February 27, 2024 Mutual Fund

Passively managed mutual funds, such as Index Funds, have gained a firm footing among investors over the last few years. In the last two years, the number of equity-oriented Index Funds available in the Indian mutual fund industry has risen from 54 to 109 as of January 31, 2024, while the AUM has nearly tripled to Rs 90,179 crore.

Apart from the fact that Index Funds offer an easy and convenient mode for gaining access to the equity market, another key reason why Index Funds have elicited investors’ interest is the high instances of underperformance of actively managed mutual funds compared to their respective benchmark indices.

But are Index Funds worth your time and money? Read on to find out…

What is an Index Fund?

Index Funds are passive mutual funds that generally track popular indices such as Nifty 50, S&P BSE Sensex, Nifty 500, etc. Index Funds are mandated to invest a minimum of 95% of their total assets in securities that form part of the underlying index. A small portion of the fund can be held in cash and equivalents to meet the liquidity requirement under the scheme.

The stocks and their weightage in the portfolio of an Index Fund are similar to that of the underlying index. For instance, if Reliance Industries has a 10% weightage in the S&P BSE Sensex, an index fund tracking the Sensex will also hold a weightage of 10% of its portfolio in Reliance Industries. The fund managers alter the composition of the scheme’s portfolio only if the stocks and their weightage in the underlying index change. Accordingly, the portfolio turnover of an Index Fund is very low.

Being passively managed, the expense ratio of Index Funds is significantly lower than actively managed funds. Furthermore, they are free from stock selection risks arising from any potential behavioural bias/judgement errors of the fund manager.

Another key characteristic of investing in an Index Fund is that investors do not have to go through the challenging task of selecting the best mutual fund from the plethora of actively managed funds available, as all funds tracking a particular index behave in the same way.

Watch this video to know the difference between Index Funds and mutual funds:

Why Index Funds don’t make much sense…

Below are some of the reasons why Index Funds may not be worth your investments:

1) Stock fundamentals and quality may be ignored

Since Index funds largely track the market capitalisation of companies that form part of the index, when a stock gains market capitalisation, a scheme has to purchase more of it to increase its weightage in the scheme as well. The fund manager has to do so even if the fundamentals do not support expensive valuations.

On the other hand, if a company falls in market capitalisation, it gets a lower weightage in the index. Subsequently, the fund manager has to reduce the exposure to such companies to match the new weightage. Such changes are done even if the long-term fundamentals of such companies are still strong.

Thus, an Index Fund buys and sells low, in contrast to the traditional wisdom of buying low and selling high.

Moreover, a stock may be included in the index even if does not fare well on qualitative parameters such as ethics and governance standards.

On the flip side, a fund manager of an actively managed mutual fund carefully evaluates each of the stocks on their profitability, revenues, valuations, and other key parameters before including it in the portfolio.

For instance, when the Adani group stocks were under pressure last year due to alleged stock manipulation and accounting fraud, most mutual fund houses trimmed allocation to the group’s stocks in their active schemes, whereas the stock holdings Index Fund schemes holding the stocks remained largely unchanged.

2) Anchored to past winners

The portfolio of an Index Fund is usually skewed towards a few large companies that are market leaders and thus carry high weightage in the index. While this appears to be a safe investment strategy, it is important to note that these companies gained large capitalisation due to strong performance in the past. Historical data suggests that past performance may or may not sustain in the future.

Since several index heavyweights are market leaders, they may witness saturation in terms of earnings growth going ahead. As a result, the upside potential on such stocks may be limited due to slower earnings growth.

Meanwhile, active mutual funds have the flexibility to trim allocation to such slow-growth companies and replace them high-growth companies or unlock potential in value stocks.

For example, the share prices of the erstwhile fastest-growing private lender, Yes Bank, started cracking between 2018 and 2019 when the RBI discovered several lapses and regulatory breaches. Accordingly, active mutual funds significantly pared exposure to the bank shares during this period. However, the stock was excluded from the Nifty 50, Nifty 100, Nifty 500, and Nifty Bank index only a year later in March 2020.

Index Funds can only sell stocks with stagnant growth if their performance deteriorates consistently and is finally excluded from the underlying index. Often there could be a long gap between the time a stock’s performance deteriorates and when it is finally delisted from the index and is replaced with a better-performing stock.

3) May not protect against downside risk and volatility

Active funds have a predefined investment universe and market cap limit that they need to adhere to. Mutual fund norms also require actively managed schemes to follow a single stock limit of 10% to avoid concentration risk. This prevents them from taking full advantage of the rally in these select stocks if they grow beyond the specified limit. This may result in underperformance of active funds compared to passive funds such as Index Fund, particularly during polarised market rallies.

Since the single stock limit of 10% does not apply to Index Funds, they outperform active funds during market rallies.

That said, unlike passive funds, actively managed funds are better poised to take advantage of dynamic market conditions and make tactical allocations in attractive-looking stocks/sectors/market cap, depending on the outlook. This enables actively managed schemes to limit downside risk during bearish market phases, while Index Funds may witness higher downside, especially if the index heavyweight stocks come under pressure.

As we can see in the table below, actively managed Large Cap Funds limited the downside risk better than the Nifty 50 Index Funds, while their performance during the market upcycle was reasonable.

[Read: Should You Invest in Nifty Index Funds as Large Cap Mutual Funds Underperform?]

Market cycle performance: Large Cap Fund vs Nifty Index Fund

Past performance is not an indicator for future returns
Direct plan – Growth option considered. Returns under 1 year are absolute and those above 1 year are CAGR
Data as of February 23, 2024
(Source: ACE MF, data collated by PersonalFN) 

To conclude:

Investors who are happy with market returns may continue to prefer Index Funds. For investors looking to earn respectable alpha over the long run, actively managed mutual funds can be a better choice compared to Index Funds.

Active funds have the flexibility to buy/sell stocks depending on the changing market dynamics and outlook which can help them do well during upside and downside market conditions. Even though there can be underperformance in the short to medium term, most actively managed funds focusing on quality stocks can reward investors with optimal risk-adjusted returns in the long run.

This article first appeared on PersonalFN here