Index Funds

Isn’t it good to invest in index funds if generating alpha is difficult?

The index funds are slowly gaining traction amongst investors. These funds are being given serious consideration even for replacing some of the actively managed large-cap schemes in an investors’ portfolio.

In this blog, we seek to discuss if it makes sense to invest in index funds if generating alpha is getting difficult in the market but before that let’s start with the basics to see what is index fund and actively managed funds.

Read on!

What is an index fund?

A type of mutual fund that has a portfolio matching or tracking any of the market indices such as the S&P BSE Small Cap Index. These funds are said to provide broader exposure to the market and comes with a low expense ratio, and turnover.

What is an actively managed fund?

An actively managed fund is one that is managed by a fund management team comprising of the portfolio manager and team of research/investment analyst. The primary objective of the actively managed funds is to provide better returns against the benchmark by taking bets that are not in the index in different proportion.

Why index funds are on the radar now

The following two regulations by the regulator, Securities, and Exchange Board of India (SEBI) has resulted in index funds finding a mention on the investment’s radar –

  • Re-categorization of funds conducted by the regulator
  • Disclosures of fund’s performance again the Total Returns Index (TRI). In TRI method of computing returns, the impact of dividends earned by the underlying shares of the index is also included.

These factors do not directly impact the index funds but have put these funds on the investment map by unveiling the reality of actively managed funds more transparently.

Let us see the performance for 2018.

Percentage of funds outperformed by the index

Source: SPIVA India Scorecard End year 2018

Average fund performance (Equal weighted)

Source: SPIVA India Scorecard End year 2018

As can be seen, in 2018, the fund managers of the large-cap and the Equity-Linked Saving Schemes (ELSS) schemes struggled to beat their respective benchmark with more than 90% active funds underperforming their respective benchmarks in both the categories. Also, across all the period, the actively managed large-cap equity funds underperformed the S&P BSE 100.

What went wrong?

All this while, schemes were being managed based on the whims of the fund manager and no proper labeling. For example, in the case of a large-cap fund, to improve the performance, the fund managers tend to add mid-cap stocks and small-cap stocks as well. This leads to large-cap stocks outperform the benchmark by a wide margin. In this, investors tend not to ascertain the risk; the fund managers were taking to generate this outperformance.

What is the road ahead? Will it be difficult to generate alpha?

We believe, in India, the actively managed funds will continue to outperform because of the information asymmetry that is seen in the mid-cap and the small-cap segment. We believe, while generating alpha is getting difficult in the large-cap space, there remains tremendous opportunity in the other segment of the market.

Also, in a developing market like India, a good fund manager tends to catch a stock or sectoral trend much earlier than it gets reflected in the index. Hence, the probability of active funds outperforming is higher in the longer run, especially in the Indian context.

What should you do?

Over a longer period, for a fund manager to generate alpha may not be feasible at all times. However, returns from index funds are generally very much in line with at of the market irrespective of the time horizon. Thus, your index fund can be a good strategy, mainly owing to its less bumpy ride in a volatile time.

How much to invest?

For an investor, who has adopted the path of equity for their long-term goals, diversification is essential, particularly across categories. In this scenario, we believe around 10-15% of the overall portfolio should be allocated to index funds. Tarrakki Research recommends investing in UTI Nifty Index Fund, IDFC Nifty Index Fund or Nippon Index Fund -Sensex Plan instead of a large-cap fund. To know more about the funds, simply download the Tarrakki app today from iOS and Android.

For more risk-averse investors, the share of index funds could inch higher to around 45-50%.

Who should invest in index funds?

We believe index funds are for all types of investors. As the market is penetrating, investing is becoming more of low cost investing vs. high cost investing. We believe the low cost investing such as the index funds will provide returns if you stick to it for the long-term given the under-performance of large cap fund managers and also because of smaller room of alpha in the segment.

To conclude, we can say that India is a developing economy, and in the overall market, there are segments where information asymmetry still exists. These segments always provide an opportunity for alpha generation, which can be manifold. On the other hand, the Blue chip or large-cap names are well researched, and it often becomes difficult to outperform the total returns of the index. Lastly, index funds are an excellent way to participate in the broader market that comes at a cheaper cost and is free from the active participation of the fund manager. Having a partial allocation to index funds helps in minimizing the overall portfolio volatility. To invest in index funds, feel free to sign up for Tarrakki account because mutual fund matlab Tarrakki. Download the app today from iOS and Android.

Should you need any assistance, feel free to get in touch with us, and we shall be glad to assist in your journey of financial freedom.

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