Recently, the Avanza Bank of Sweden announced the launch of the world’s cheapest investment fund. This has been confirmed by Morningstar which is the largest firm dedicated to mutual funds research in the world. One of the key criteria for selecting an investment fund is the costs involved. In India, the average total expense ratio (TER) on equity funds in India range from 2.3% to 2.5%. Avanza Bank of Sweden is literally shaking up the global fund management market with the lowest cost fund ever. It has launched a fund with a management fee of just 0.05% and a total annual cost of just 0.10%. That is a TER of just 0.10%. In a globally competitive fund management market, this is likely to be majorly value accretive. Obviously, at 0.10% TER, it can only be an index fund without any active management support. Vanguard and Blackrock, two of the world’s largest funds handling over $11 trillion between them are predominantly index funds. In technical parlance it is called passive investing. Here is why passive investment is important. But first a quick tone on index funds!
Passive investing as a strategy with index funds
Index funds are the best example of passive investing. What an index fund does is to just replicate an index like the Nifty or the Sensex. Your earn returns that is at par with the index. The fund just buys the index in the same proportion and the market does the rest. There is no stock selection and no active investing. Passive investing needs to be understood in contrast with active investing. In active investing the fund manager has discretion to buy stocks to enhance returns for the fund holders. Diversified equity funds are examples of active funds. An index fund purely invests its corpus in the index. If the index fund is benchmarked to the NSE Nifty, then the fund will buy all the stocks in the index in the same proportion as the index. The only time the portfolio is changed is when the index components change. The idea here is to just replicate the index returns as close as possible.
If you look at the Sensex over the last 38 years since its inception then an investment of Rs.100 has grown to nearly Rs.38,000. If you add up the dividends, then it is a lot more. The moral of the story is that even indices can create wealth over the long term and that is where index funds as a product and passive investing as a concept gains prominence.
What are the key merits of investing in a passive index fund?
- An index fund promises good returns over a longer time horizon. You can gain good returns even if you don’t try too hard to find good stocks. As seen earlier, take the case of the Sensex. The Sensex has a base value of 100 in 1979 and over the last 39 years it has given 38-fold returns. The Nifty has its base in the year 1995 and has given 11-fold returns over the last 23 years. What global investors are realizing is that if you invest in passive index funds the cost saved in the form of lower TER is so significant that it really make a voluble difference to your net returns.
- The problem with most diversified equity funds is that there is a huge element of fund manager discretion in their decision making. Directly or indirectly, the personal choices and biases of the fund manager encroach upon the fund management policy. The passive index fund is a lot more rule-based. With little discretion, the returns become more predictable over the long run. At least, as an investor, your returns are not contingent on the individual choices of the fund manager.
- In the last annual general meeting (AGM) of Berkshire Hathaway at Omaha, Warren Buffett had lauded the efforts of John Bogle, the founder of Vanguard Funds. Vanguard is one of the world’s largest asset managers with over $4.30 trillion in AUM. According to Buffett, Vanguard had saved billions of dollars in costs for mutual fund investors by adopting an index based strategy. In India there may still be alpha opportunities, but as these opportunities start thinning, index funds will make a lot more sense.
- Before the SEBI classification of mutual funds came into play, many diversified funds in India today were essentially index funds as a chunk of their portfolio was invested in index heavyweights. You ended up paying a higher Total Expense Ratio (TER) for marginal return benefits.
But index funds and passive investing may not be roses all the way
- In volatile market conditions, the fund manager can be more proactive. For example, if the market is too volatile, then the cash allocation can be increased substantially. However, an index fund does not have that flexibility as it has to be fully invested in the index at all points of time. This lack of flexibility does work against the index funds and also against passive investing as a concept.
- Index funds are vulnerable to the risk of tracking error. It is the extent to which the index fund does not track the index. There are various reasons for tracking error in an index fund. It may occur in an index fund due to liquidity provisions, index constituent changes, corporate actions etc. This is a risk that investors in passive funds must be conscious of.
- In a country like India, where there are enough alpha opportunities index funds are likely to underperform the actively managed funds. Also, index funds miss out on the all-important mid cap and small cap space which is where most of the alpha comes from.
Index funds in India are still quite expensive by global standards and this Swedish experience will lead a lot of other passive funds to rethink their passive strategy. This is surely an area with huge potential.
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