The benchmark most people use to track the performance of their equity mutual funds is the BSE SENSEX Index or the Nifty Index (NIFTY 50). The BSE Sensex Index consists of 30 stocks and Nifty of 50. These indexes represent large, well-established and financially sound companies across key sectors.
The idea of an index fund is to replicate the stock composition and hence the performance of the index instead of trying to beat it. Index funds are very popular in the United states but are yet to catch up in India. The main belief is that Index funds are not relevant in the Indian context, where majority of funds outperform the equity benchmark. However this belief is not true and hopefully the rest of this article will convince you of the same. Index funds are also sometimes referred to as Passively managed funds.
Most mutual funds that we are exposed to are Actively managed. Here there is a fund manager who’s main objective is to try and beat the Index or the benchmark. You will see that in the long run most actively managed funds do worse than the Index.
I recommend you consider Index funds only if your investment horizon is LONG i.e 10-15+ years. If you are looking for immediately returns over the next 1-3 years you may be better off with an Actively managed fund.
BSE Sensex Performance over 38 years
Check the chart below of the BSE Sensex Index over the past 38 years. It has given a 16.1% compounded annual return (CAGR)
So 1 lakh invested in the Sensex Index on 31st Dec 1979 will get you approximately 2.9 crores on 31 Dec 2017.
The data also shows that over a long period the expected returns from the stock market is also relatively stable. There has not been a single 15 year period where the market returns has been negative. Do you feel confident you can find an actively managed mutual fund that will give you 16+% returns over a 38 year period?
Nifty 50 and Sensex are not the only indexes (however the most popular in India). Below are some other Indexes
Other Indian Indexes
S&P BSE SENSEX
Consists of 30 stocks representing large, well-established and financially sound companies across key sectors.
The NIFTY 50 is the flagship index on the National Stock Exchange of India Ltd. (NSE). The Index tracks the behavior of a portfolio of blue chip companies, the largest and most liquid Indian securities. It includes 50 of the approximately 1600 companies listed on the NSE, captures approximately 65% of its float-adjusted market capitalization and is a true reflection of the Indian stock market.
Nifty NEXT 50
It represents the next set of liquid securities after the NIFTY 50. Is considered the nurturing ground for stocks which could enter the Nifty 50 hence has potential to outperform the giant cap based index like Nifty 50 and BSE Sensex. Companies in this index are a perfect mix of not being giant enough for slow growth and not being small enough for failure.
Nifty MID100 Free
The objective of the NIFTY Free Float Midcap 100 Index is to capture the movement and be a benchmark of the midcap segment of the market.
Nifty SML100 Free
Designed to reflect the behaviour and performance of the small cap segment of the financial market. The NIFTY Full Smallcap 100 Index comprises 100 tradable stocks listed at the National Stock Exchange (NSE).
It represents the top 500 companies based on full market capitalisation from the eligible universe.
Unfortunately I found that most mutual funds seem to focus only on the BSE Sensex Index and Nifty 50 index and don’t offer other Indexes. I personally would have liked to invest in a NIFTY 500 Index fund. However given the currently availability I have focused on investing in the Nifty NEXT 50 Index.
Index Funds Vs Actively Managed Mutual Funds
I have compared all the equity mutual funds with Index funds over the last 15 years and below was my findings. I have considered all the funds i could find with a launch date greater than 15 years.
Out of 102 Equity funds the Nifty Next 50 ranked 7th! Yes – this index fund would beat 94 out of 102 actively managed equity funds. Refer to the chart below
(The data listed here are the returns from March 2002 to March 2018)
I believe that in a 20-25 year duration the Nifty Next 50 might ranked among the top 3.
Also notice that even the bottom performers have done better than your typical bank FDs and other debt funds. But more on that later.
Why do Index Funds do Better?
Low Expense ratios
Index funds typically have an expense ratios between 0.20% to 0.60% while actively managed mutual funds have a expense ratio of 1% to 3%. These expenses are paid by you each year regardless of how your fund is doing.
Eg Lets say you invest Rs 1,00,000 lumpsum in a mutual fund and after the 1st year the underlying stocks remained exactly the same in price, you would end up losing Rs 3000 (if the expense ratio is 3%) and the new value of your fund is now Rs 97,000 instead of Rs 1,00,000
Now 2-3% may sound like a small amount about over a long time (15-20+ years) this amount compounds and adds up to a lot. You need to pay these expenses even when your funds do badly.
Today’s Top Ranked Funds are not necessarily the Top Funds in the Future
1. As more and more investors are attracted to a specific mutual fund, the manager is presented with a significantly large amount of cash. The risk that arises in this situation is that to put the cash to work as soon as possible, some managers may purchase additional instruments that are not optimal for the fund’s investors.
2. Most mutual funds stick to a specific styles like large cap value, small cap growth, etc. When their style is in favor they will typically do well. When their style is out of favor it is hard for them to do well and we all know that styles don’t stay in favor forever.
Instead of using past performance, like a star rating, to judge whether you should buy a fund or not, you should be trying to figure out if the performance is sustainable.
3. Fund managers may not necessarily stick around for the long term. If you look at a 15-20 year period your fund would have gone through multiple fund managers with their own investment philosophies, I doubt that’s going to have a positive impact on your overall returns.
Long Term Capital Gains Tax (LTGT)
With the introduction of 10% LTGT it’s even more important to hold on to your mutual funds and defer your tax payments as long as possible. The key here is to find a good mutual fund and hold it for 15+ years. If you keep switching across mutual funds and pay Long term or Short term tax you will end up saving much lesser money.
A rupee that doubles every year for 25 years grows to 3.35 crores. What do you think the number will be if you take the same scenario and assume that gains are taxed each year at 10%?
The ending balance is only 93 lakhs. This number would be a lot lower if you sell anything within a year and pay 15% short term tax.
If you hold on to the right shares for a bunch of years you could end up with some really extraordinary returns. It’s what Warren Buffet and Charlie Munger call Sit-On-Your-Ass Investing. However a fund manager’s performance is constantly judged and he is forced to constantly buy and sell shares instead of taking some really long term calls and waiting it out. This issue has been mentioned by Peter Lynch who is one of the highest regarded fund managers in the world. That’s another reason I feel Index funds works so much better than Actively managed funds.