Why isn’t investing in index funds popular in India?

by Manshu on March 13, 2012

in Investments

Index funds are a relatively small part of the overall mutual fund industry in India, and this is markedly different from the west, where index funds do quite well, and in fact the biggest fund in the US is an index fund (SPY) that tracks the popular S&P 500 index.

I think there are two aspects to this – the first is that actively managed funds have performed better than index funds in the past and people expect that to continue in the future as well, and secondly, index funds aren’t really low cost in India.

First, let’s look at some data to see why I say actively managed funds have performed better than index funds.

To get this data, I took the list of mutual funds from my post on the best balanced funds and saw how they performed vis-a-vis GS Nifty BeES which is the biggest index ETF right now, and is fairly low cost as well.

Here is a table that shows the results.

S.No. Mutual Fund 3 Year Return 5 Year Return
1 Goldman Sachs Nifty BeES 28.34% 8.29%
2 HDFC Prudence 38.64% 14.94%
3 DSPR Balanced Fund 25.05% 12.37%
4 HDFC Children’s Gift Plan Fund 37.61% 13.85%
5 Reliance Regular Savings Balance Fund 32.91% 14.81%
6 HDFC Children’s Gift Plan Fund 37.61% 13.85%
7 Birla Sun Life 95 29.77% 12.45%
8 FT India Balanced 22.85% 9.14%
9 Canara Robeco Balance 30.31% 12.04%
10 Tata Balanced Fund 29.58% 12.44%

As you can see, with the exception of DSPR Balanced Fund and FT India Balanced Fund in the 3 year period, the balanced funds did better than the index fund in the 3 and 5 year periods. I’m sure there are plenty of other examples like this and in this environment it just isn’t possible for index funds to get popular.

The question then is why do active funds do better than index funds in India? I’ve seen several theories on this but none that seem very convincing. Perhaps the confluence of all the factors make them do better or it could be something that isn’t talked about at all right now.

The chief theory that I’ve heard a lot is that the markets in the west are so deep and developed that they are efficient to a large extent and it is difficult for stock pickers to find mis-pricings and benefit from them. Indian markets are not so efficient so stock pickers are still able to find undervalued stocks and benefit from owning them. While this may sound plausible, the thing that makes me a little wary of this theory is that markets in the west are quite volatile as well so people can take advantage of stock prices when they are low, plus there are a lot of hedge funds that do beat the market so it isn’t like the market is very efficient.

The second aspect is that of cost and tracking error of the index funds themselves. The whole point of an index fund is that it should be extremely low cost since there is no active management needed but that low cost hasn’t really materialized in the Indian market.

In March 2010 I did a list Nifty index funds and Sensex Index funds, and saw that a lot of them charge in excess of 1% recurring expenses and that’s simply too high for an index fund. Since then there have been funds that charge much lower expenses, most notably the IIFL Nifty ETF that has an expense ratio of 0.25% which is the lowest of any index ETF till date. The biggest Nifty ETF – Goldman Sachs Nifty BeES ETF is also a low cost ETF which has expenses of about 0.50% and has been around for a decade now, but as a category – the low cost has still not become a norm, and that makes a difference to the returns.

So, I would say that the two main benefits of investing in index funds – which is low costs and doing better than active funds have been more or less absent in India so far and it’s hard to say why. People who want the benefit of passive investing feel that by creating a SIP in an active mutual fund – you enjoy the same kind of benefit and the past returns show that it has been beneficial as well.

I don’t know whether this trend will change or not but keeping all this data in mind, it is hard to invest all your money in passive index funds.

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