Why index funds started working in India

I have been investing in Mutual Funds in India for 16 years now, since 2005.

It has been a great ride so far and despite my various mistakes of getting in and out of the market, it has provided one of the best wealth boosters in my portfolio.

Thanks to various publications like Outlook Money and Value Research Online, the selection of good mutual funds with long term track record had not been very difficult, for those who cared to follow. Moreover, India is not like the US and has lesser number of fund houses and funds. I think India has about 2500 funds whereas US may have 3 times more. Still it’s a lot now and making sensible choice is difficult.

The number of funds have grown astronomically in India in very recent years. However in my experience, most funds are just fads and trying to get investors’ money by offering Rs. 10/- NAV at New Fund Offering.

A big myth propagated by the fund industry is equating Mutual Fund Launch with the IPO of a stock. In a Mutual Fund, it does not matter whether the NAV is 10/- or 100/-. Eventually the rise in the value of the underlying Net Asset Value over time will generate the real returns. If both funds (new and old) invest in the same portfolio of stocks and the portfolio appreciates by 20%, then one fund’s (new) NAV will be 12/- and the other one (old) will be 120/-. If you invested 1000/- in either, the final value of your portfolio will be 1200/-, only the number of units will be different.

Using a similar logic, I will justify why Index Funds will work better than actively managed funds. Before that, let me explain what is an Index Fund vs. an actively managed fund. An Index fund simply invests in a predefined set of stocks called an Index (like the Nifty or Sensex), whereas an actively managed fund will rely on the fund manager to choose stocks that will outperform a benchmark index.

In the latter case, the fund manager is always under the compulsion to beat or at least match the index the fund is benchmarked against. This is possible but risky and inconsistent. Over time, as the universe of funds expands in India, most fund managers will have same information and will find it hard to do something very spectacular.

Moreover even if one fund manager identifies a potential multi-bagger, he will rather be right in choosing funds closer to the Index, than taking a contrarian bet and end up not beating the Index. A few times contrarian bets will work for some funds, but not all the time.

This is recently seen in the performance of large cap funds where they failed to beat the Index. Mid caps are the only remaining playing field for fund managers. Small caps are anyway risky in India and with the present COVID situation breaking the economy, small caps will be further illiquid or many companies will go out of business.

The above reasoning are not my own, but has been proven over time in the US. John C. Bogle, the founder of Vanguard and the father of Index Investing had predicted this shift in the US long time back.

The same principles today are very apparent in India, although some experts are still trying to justify costly (expense ratio of 2% or more) actively managed funds for their own commissions.

With low cost (0.1%) and long term Equity investing vehicles like Index Funds and NPS (National Pension System), the days of sensible investing and all power to the investor is fast approaching.

The below is from Value Research Large Cap category of fund recommendations with Expense Ratio and 1 year returns. See the 4 (in bold) out of 8 top funds are Index funds with equivalent returns at a fraction of the cost.

PDF	SBI Bluechip Dir		Best Buy	EQ-LC	Jan-13	0.98	65.66	8/67	26,464
PDF	UTI Nifty Index Dir		Best Buy	EQ-LC	Jan-13	0.19	64.03	13/67	3,669
PDF	Mirae Asset Large Cap Dir		Best Buy	EQ-LC	Jan-13	0.53	63.08	25/67	23,993
PDF	UTI Nifty Next 50 Index Dir	Unrated	Best Buy	EQ-LC	Jun-18	0.34	59.34	44/67	986
PDF	Axis Bluechip Dir		Best Buy	EQ-LC	Jan-13	0.50	52.19	65/67	25,183
PDF	Kotak Bluechip Dir		Buy	EQ-LC	Jan-13	0.92	65.18	10/67	2,411
PDF	HDFC Index Nifty 50 Dir		Buy	EQ-LC	Jan-13	0.20	63.88	14/67	2,928
PDF	SBI Nifty Index Dir		Buy	EQ-LC	Jan-13	0.09	63.80	15/67	1,189

Another reason for shifting to Index Funds is to reduce the number of funds one needs to be invested in. With no active fund manager bias, one or two Index Funds offer a diversified and manageable portfolio.

For more data driven analysis of Indian Mutual Funds, see my previous post below.

Visualizing Indian Equity Mutual Funds