Are Index Funds not a Good Investment in India?

The Indian equity markets are at an all-time high. This can be largely attributed to the large inflow of savings which is being channelized from the economy to the stock market. A lot of these savings are regularly routed via the mutual fund route. The Indian market is still developing. Hence, a lot of money is invested via actively managed funds, i.e. funds in which fund managers decide the portfolio of shares and the percentage in which these shares that need to be bought.

However, this is not the case in countries like the United States. In the United States, a large number of investors use index funds to invest their money. Index funds are a particular type of mutual fund. They are passively managed. This means that the fund manager does not decide which shares need to be bought and in what percentage. Instead, they blindly follow a given index like S&P 500 which is a combination of the top 500 shares in the American stock market.

Warren Buffet and Index Funds

The world’s richest investors, Warren Buffet, is a big fan of index funds. It is said that Warren has asked his family to invest their money in index funds after his death. This is because he believes that index funds offer some of the best returns in the market. These funds are extremely cheap and have low-cost ratios. On an average, index funds only charge 0.10% per annum expense fees whereas mutual funds charge 2% to 3% per annum as expense fees. Over a long period of time, this low cost becomes a huge advantage and ends up beating most actively managed funds.

Since Warren Buffet has praised and enumerated the advantages of index funds, there is absolutely no doubt that they are a good investment option in America. However, the mutual fund industry in India wants to discredit index funds. This is the reason why they give a wide variety of reasons as to why index funds are not a good option in India.

In this article, we will have a closer look at some of the arguments against index funds.

Most Mutual Funds Outperform the Market

Firstly, mutual fund managers in India claim that the Indian market is not like the United States. In the United States, most actively managed mutual funds find it difficult to beat the benchmark indices. However, in India, that is not the case since most actively managed funds do beat the benchmark indices.

It turns out that mutual funds do not always beat the index. In reality, they were misreporting their gains. While comparing their performance to index funds, mutual funds would calculate only the price increase in the value of the index. They would omit the dividends received by the index fund while benchmarking their returns. On the other hand, while calculating their returns, they would consider both the price gain as well as the dividends received.

The Indian regulator SEBI has taken note of this discrepancy. They have now asked all mutual funds to compare their performance with a Total Returns Index (TRI) instead of Price Return Index (PRI). As a result of this reclassification, the Indian market also mimics the result of the American market, i.e. index funds beat most of the actively managed funds in the market.

Markets are not Efficient

Proponents of mutual funds claim that the Indian markets are not efficient. Hence, using active investing is better since finding undervalued stocks is more likely in the Indian context.

What the mutual fund managers are trying to say is that American markets are run by professionals while this is not the case in the Indian market. Once again, it turns out that they are misreporting numbers. The reality is that most of the money which is invested in the Indian stock market belongs to Institutional Investors. The mutual fund managers smartly omit the fact that American mutual funds are also investing in India. When they are talking about mutual funds, they are only talking about Domestic Institutional Investors and not about Foreign Institutional Investors.

The retail investor amounts to only about 16% of the entire market. Hence, the other 84% is smart money. It would, therefore, be unfair to say that the Indian markets are not as developed or efficient.

The Indices are not Diverse

Many mutual fund managers claim that the Indian indices are not well diversified. Hence, they are risky as compared to their American counterparts. For instance, the Indian Nifty 50 is composed of only 50 shares whereas, on the other hand, the S&P 500 is composed of 500 shares.

However, it needs to be understood that the size of the Indian markets and the US markets are not the same either. The US markets have a much larger market cap, and hence a larger index is needed. In India, Nifty 50 captures more than 50% of the market capitalization and hence is as diversified as it needs to be. The number of stocks in the index is irrelevant.

Tracking Error

Lastly, mutual fund managers complain that index funds do not exactly mimic the actual index. There is some amount of tracking error which takes place. This is because 100% of the money cannot be invested. 10% of the money has to be held for redemptions and other contingencies. However, the tracking error is negligible over the long run. Only about 15% of the index funds have a tracking error of greater than 1% over the long run. Hence, this argument isn’t valid either.

The bottom line is that index funds are as good an investment option in Indian as they are in America.

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