Over the last few years, equity index funds have largely delivered on their mandate — that of moving in tandem with their underlying indices, say, the Sensex or the Nifty.
For most of the 24 index funds, the tracking error — the difference between their returns and that of the index they are meant to track — is less than 1 per cent.
This is partly explained by the funds’ expense ratios, which varies from 0.3 to 1.8 per cent of their assets under management.
Among the better performers in this category are the Nifty plans of HDFC, ICICI Pru and IDFC as also the Sensex plans of HDFC and Tata mutual funds.
These funds have delivered returns better than the benchmark indices across most time periods. The best performer, HDFC Index Fund - Sensex Plus Plan, has extra returns of 1.8-2.8 per cent — it has benefited from being able to invest 10-20 per cent of its corpus in stocks such as Solar Industries India and Kirloskar Pneumatic which do not figure in the Sensex.
But in that sense it is not a pure index fund and entails higher risk.
Investors who seek to outperform the benchmark should consider well-run actively managed diversified funds which have the potential to do much better than passively managed index funds or their variants. Over the last year, actively managed large cap funds have, on an average, outperformed the Sensex and Nifty by about 3-4 percentage points.
Among the pure index funds, those with lower expense ratios such as IDFC Nifty and ICICI Pru Index Fund – Nifty are the best performers while those with higher expense ratios such as SBI Magnum Index Fund, Tata Index Fund – Plan A (Nifty) and Taurus Nifty Index Fund lag the others.
Besides the expense ratio, an index fund’s cash levels and difference in the weight of its stocks compared with the benchmark determine its tracking error. The lower the tracking error, the closer the fund is to its mandate of replicating the underlying index returns.
But a more optimum way of taking passive exposure to benchmark indices is through exchange-traded funds (ETFs).
ETFs outdo index funds
These funds generally have lower expense ratios and consequently lower tracking errors than index funds.
Over the last few years, most benchmark indices linked ETFs have done better than similar index funds. For instance, over the last year, the average return on Nifty and Sensex linked ETFs is 34.2 per cent compared with the 33.3 per cent average return of the index funds.
But go only for those ETFs which have adequate liquidity on the exchanges; else, the market price at which you exit may be at a significant discount to the ETF’s net asset value.
This article was originally published in >The Hindu Business Line.
