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Are index funds and ETFs better options?

March 27, 2008 11:22 IST
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With a steep fall in the markets since January this year, mutual funds have suffered heavily. Sample this: the year-to-date (January 1 to March 24) category average return from equity diversified mutual funds is down by 32.36 per cent, and index funds, including exchange traded funds (ETFs), have slipped by 26.41 per cent.

However, the fact that the latter has fared better than the former reopens the long standing debate: are index funds and ETFs better options than equity diversified funds?

In fact, the debate was opened up in the US by John Bogle, author of Common Sense on Mutual Funds and former chairman of Vanguard, which specialises in index funds.

Bogle has argued that index funds are superior to actively-managed diversified funds, which cost higher at over 6 per cent because equity diversified funds have dedicated fund managers who pick and choose winners in the market.

For this expertise, Indian mutual funds take 2.25 per cent as entry fee from the investors.  Though the Securities and Exchange Board of India (Sebi) has recently removed this entry load for investors who invest directly in mutual funds, most still depend on distributors to invest in the stock market through mutual funds.

Besides the entry fee, such investors also have to pay fund management charge, which is another 2.25 per cent a year. On the other hand, index funds have an average load of around 1 per cent and other expenses of between 1 and 1.5 per cent.

ETFs also come cheaper with almost no entry load and a total expense of .25 to .5 per cent.  This is because in both index and ETFs, the fund manager allocates the asset under management (AUM) according to the index.

For instance, a fund like Nifty Junior BeEs will invest in stocks that are on the Nifty Junior index and in the same proportion. And the objective of the fund will be to give returns that closely correspond to the returns of the stocks on the index.

However, ETFs work out even better than index funds because they can be exited at any time during the day, whereas in index funds only the "end of day" value can be received. As far as fund managers go, there is a clear division whether investors should opt for the index or the diversified equity route.

According to Rajan Mehta, executive director, Benchmark Mutual Fund, which operates four index funds, "For a long-term investor, index funds are the best bets".

However, SBI Mutual Fund chief investment officer Sanjay Sinha said that since the growth story of the country was still intact, it provided enough opportunity for diversified funds to easily outperform the benchmark indices for the next 3-5 years.

"Index funds are for investors putting money with a horizon of over 10-year period," Sinha added. If the category performances of the two funds are considered, diversified funds have given more returns, but in patches.

During the last calendar year (January to December 2007), when the markets were booming, index funds gave a return of 49.97 per cent, whereas equity diversified funds increased the investor's wealth by 59.52 per cent.

Also, while the top three equity diversified funds gave an average return of 107.54 per cent, the top three index funds averaged only 65.64 per cent. However, in the calendar year 2006, when the Sensex was in the range of 9,000 to 13,000 points, index funds returned 39.13 per cent, while diversified equity gave 34.7 per cent returns.

More interestingly, the year-to-date figures clearly reflect that just following the index would not have given as much heartache to the investors as actively managed funds.

"In the past, diversified funds have given better returns compared to index funds. But as the size of assets under management is rising, funds are increasingly finding it difficult to beat the benchmark consistently," added Mehta.

Another fund manager said that as markets were becoming more efficient, the gap of returns between diversified and index funds were shrinking. So, where should the investors park their funds? Financial planner Gaurav Mashruwala said that he has been advising his clients to slowly move towards index funds.

"In the last two years, with more efficiency in the stock markets, whenever there are renewals of systematic investment plans, I have asked the clients to move money to index funds," he said.

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