All about index funds and costly errors

John Bogle, founder of Vanguard Group, the global leader in index funds, would find it difficult to sell index funds to Indian investors. Bogle's argument that well-managed index funds are superior to actively-managed mutual funds in the long run will find few takers here.

The problem, experts say, lies in the product itself. Index funds ideally should contain the same stocks and in the same proportion as the underlying index. Since they mirror the index, the returns should be exactly the same - a test that many index funds fail in India.

The difference in returns between the underlying index and fund - called tracking error – should not be more than 25 basis points. But in case of Indian index funds, the difference is quite high - 100 basis points. Sometimes even more.

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According to Value Research data, the Nifty has returned 12.70 per cent in the past one year while index funds have given returns of 11.3-13.9 per cent. Clearly, many index fund managers are not following their mandate.

Gul Tekchandani, investment expert, explains, "When global investors put money in index funds, the objective is to make money through equities with minimum risk and cost. So, returns of even 50 basis points more or less than the index mean a rap on the knuckles of the fund manager."

The average return of an actively-managed large-and-mid-cap fund in the past year is 13.35 per cent with the best scheme returning as much as 21.7 per cent. Even over three and five years, returns from actively-managed funds are higher than index funds.

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Another important factor that Bogle stressed was the low cost of index funds making them ideal for long-term. The cost on an average is 20 basis points in the US. In India, most fund houses charge five times higher - some even more.

Actively-managed funds charge 2-2.5 per cent for stock picking. So, for 75-100 basis points more, if there is substantial difference in returns, there is little reason to go for index funds," says a financial planner.

Even fund houses do not promote index funds as low-cost investing options aggressively.

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The quest is always to reduce costs. No wonder, Vanguard recently shifted its benchmark index from MSCI to FTSE to save on licensing fee - a key expense in index investing.

Many say that the investing environment does not allow for complacency over the long term. "In India, much like in other emerging markets, the volatility due to environment is very acute. Hence, positions have to be monitored regularly," adds Tekchandani.

It's exactly what a passive investor in equities should not be doing. Ask Bogle.