What to consider before selecting an index fund

Active and passive management are two different ways of managing portfolios. An active fund manager’s objective is to outperform the benchmark on a risk-adjusted basis, while a passive fund manager’s mandate is to replicate the portfolio and performance of the benchmark. With active funds underperforming, a lot of interest and assets under management are moving into passive funds. Index funds are the most popular type of passive funds. In India, the first index fund was offered in 2001 and since then index funds have come a long way. As of June 30, 2022, there were 94 index funds in India managing around $83,000 crores. Currently, 19 index funds track the Nifty 50 and invest in the same 50 companies as the index (same ratio).

A less sophisticated investor might be attracted to an index fund that outperforms the index or other index funds. Sophisticates worry about how close the fund is to replicating the performance of the index. The key performance statistic for evaluating index funds is the tracking error (TE), which captures the deviation between the fund’s performance and the performance of the benchmark index. Sebi has provided standards for TE. The fund’s performance may deviate from the index’s performance for two reasons. One, for the fund’s portfolio management fees as it is a real portfolio, while the underlying index is a paper portfolio. Low expense ratio (ER) is not a guarantee but a necessity for return replication. The table shows the ER for Nifty 50-based index funds (select funds only). All these funds have the same values ​​in practically identical percentages. However, they have substantially different ERs. In both the direct and regular plans, the difference between the highest and lowest ER is 80 bps. The difference between the ERs under the direct plan and the regular plan is also notable and, in some cases, reaches 81 bps.

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The second reason for the underlying portfolio deviation is the need to hold cash to manage inflows and outflows. In theory, an index fund has a beta of one. However, in practice, a fund’s beta exposure could differ from one, due to its cash holdings. This can be captured by calculating beta minus 1. Funds with large AUM (see table) seem to have an advantage here.

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How investors chose index funds provides interesting insights into investor behavior. Rational investors should select funds that maximize their financial return. Since the underlying product is the same, funds with the lowest TE should attract the highest AUM. However, the relationship between the two is weak (see table). Marketing and distribution networks may explain why some index funds, despite high ERs and relatively higher TEs, enjoy larger AUMS. Clearly, the rationality of investors is overestimated. Of course, some of these low ER funds are relatively new and we have yet to see how they would attract investors. If investors were rational, index funds with higher ERs and higher TEs would be driven out of the market.

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Dr. Rachana Baid is a professor at the School of Values ​​Education, NISM. The opinions expressed here are personal.

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