Should you invest in index funds?

With equity markets surging sharply over the last 12 months, expectedly the performance of index funds has looked up as well. In fact the growth clocked by benchmark indices (and index funds alike) over this time frame has been so impressive, that quite a few diversified equity funds have failed to match them.

Furthermore, index funds have been in the news for other reasons as well. Recently, the Securities and Exchange Board of India (SEBI) issued a notification to the effect that expenses charged on index funds would be capped at 1.50%. This makes index funds cost-effective investment options as compared to conventional diversified equity funds wherein the expenses that can be charged to the fund are capped at 2.50%.

Index funds are typically associated with lower costs; this phenomenon is prevalent both globally and in the domestic mutual funds industry as well. The notification issued by SEBI will mean that now there is a regulation in place to ensure the aforementioned.

To sum up, there is a fair degree of investor interest in index funds at the moment and investors are evaluating the investment proposition offered by them. So should you invest in index funds? Before that, let's understand what index funds are and how they differ from diversified equity funds.

Index funds are passively managed funds i.e. the fund manager attempts to mirror the performance of a benchmark index like the BSE Sensex or the S&P CNX Nifty, by being invested in the same stocks as the benchmark index and in the same allocation. This investment style is in contrast to the active management style that is pursued by diversified equity funds. In actively managed funds, the fund manager uses his expertise and skills to select stocks from across sectors and market segments in an unrestricted manner.

To take this discussion further, now let's pitch index funds against some leading diversified equity funds and compare their performances across parameters. We have chosen the top-performing index funds over a 1-year period; conversely, diversified equity funds have been chosen based on their performance on risk and return parameters over longer time frames. From the index funds category, we have selected three funds i.e. ICICI Prudential Index and UTI Nifty Index, which have S&P CNX Nifty as the benchmark index and UTI Master Index which is benchmarked against the BSE Sensex.

Index funds vs Diversified equity funds
Diversified Equity funds NAV
Expense Ratio
DSP ML Opportunities (G) 84.40 55.6 52.0 59.8 6.73 0.44 2.00
HDFC Top 200 (G) 164.40 54.7 50.5 57.9 6.22 0.44 1.96
HDFC Equity (G) 213.45 51.9 51.6 57.8 5.75 0.45 1.84
Index Funds
ICICI Prudential Index 53.50 57.1 47.4 42.4 7.09 0.42 1.25
UTI Nifty Index (G) 38.01 55.3 45.4 41.9 7.05 0.41 0.74
UTI Master Index (G) 62.35 48.4 47.6 43.8 6.77 0.43 0.75
BSE Sensex   48.9 47.3 43.3      
S&P CNX Nifty   55.0 44.7 41.0      
(Source: Credence Analytics. NAV data as on December 10, 2007.)
(Standard Deviation highlights the element of risk associated with the fund. Sharpe Ratio is a measure of the returns offered by the fund vis-à-vis those offered by a risk-free instrument)

Over the 1-year time frame, index funds have pitched in comparable performance vis-à-vis diversified equity funds. However, over longer time frames (3-5 years), diversified equity funds rule the roost.

For example, over 1-year, ICICI Prudential Index ( 57.1%) emerges as the top performer, while DSP ML Opportunities (55.6%) comes in a close second. Over the 3-year period, all diversified equity funds have outperformed their index fund counterparts. It's the same story over the 5-year time frame as well, with diversified equity funds comprehensively outperforming the index funds.

Diversified equity funds score better than index funds on the volatility control front. HDFC Equity (Standard Deviation 5.75%) and HDFC Top 200 (6.22%) rank as the least volatile funds, while UTI Nifty Index (7.05%) and ICICI Prudential Index ( 7.09%) lie on the other end of the spectrum.

Risk-adjusted returns
Diversified equity funds have a slight edge over index funds on risk-adjusted returns front as well. While HDFC Equity (Sharpe Ratio 0.45%) from the diversified equity funds segment occupies the top position, HDFC Top 200 ( 0.44%) and DSP ML Opportunities (0.44%) share the second position. UTI Master Index (0.43%), the best performer from the index funds segment is outscored (albeit marginally) by all the diversified equity funds.

This is one area where index funds outperform diversified equity funds. Clearly, index funds across the board have lower expenses as compared to diversified equity funds, making them cost-effective investment options.

What should investors do?
While index funds have pitched in a noteworthy performance over shorter time frames (1-year), over the long-term (3-5 years), which is appropriate for evaluating equity-oriented investments, diversified equity funds dominate proceedings. Also, diversified equity funds hold the edge on risk parameters. Of course, index funds also offer benefits in terms of lower costs and ease of investing (investors can conveniently access equity markets by investing in index funds vis-à-vis diversified equity funds wherein the fund's investment style and mandate, among other parameters need to be evaluated).

The trend is unlikely to be very different going forward. This is because Indian equity markets are still in a developing phase and therefore can offer enough investment opportunities (if identified earlier on) to outperform benchmark indices over the long-term. So, well-managed diversified equity funds ( i.e. actively managed funds) can be expected to score over index funds (i.e. passively managed funds), going forward as well.

Hence it can be safely concluded that index funds don't make the grade as standalone investment avenues. Instead, investors' interests are likely to be better served by holding a portfolio comprised of well-managed diversified equity funds with proven track records across parameters and time frames. Index funds can feature therein (if required) in a smaller proportion and only from a diversification perspective.