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Why retail investors should choose to invest in index funds in current times

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One category that has been gaining interest is passive funds and specifically index funds, given the simplicity, low-cost structure and falling alpha in some of the active fund categories.

Why retail investors should choose to invest in index funds in current times
Authored by Radhika Gupta
One category that has been gaining interest is passive funds and specifically index funds, given the simplicity, low-cost structure and falling alpha in some of the active fund categories. Index funds unlike actively managed funds, passively replicate the performance of a specific index.
Their goal is not to beat the market but replicate an index as close as possible, although perfect matching is impossible, given a little tracking error.
While passive funs are an evolved category in developed markets, they are finding their feet in India. India now has as of March 2020, 110 passive funds (across ETFs and Index Funds) and AUM crossing Rs. 2 lakh crores. A program like Bharat Bond ETF, in less than a year, has grown to 25,000 crores, despite all the challenges in the debt market.
The first category that has seen some passive migration has been large-cap funds, with alpha in large-cap funds shrinking amidst a tighter universe to invest (as per SEBI guidelines, 80 percent exposure should be in the top 100 companies) and the large-cap universe becoming more highly researched.
Index funds offer the simplicity of exposure, to investors who just want to capture index returns, particularly beginners who don’t have the bandwidth to do their own analysis in picking an active fund. A simple index fund can make for a good start.
Passive can also play an important role in other categories, both debt and equity. On the equity side, globally passive funds offer geography, sector, market segment, and factor-based exposure. As investors evolve, they can choose passive funds in other categories. One such option that may be interesting for investors is passive thematic index funds as an alternative to actively managed thematic funds.
Today, there are 80 plus actively managed thematic/sectoral funds in India with an AUM of over Rs. 54,000 crore (August 2020). The steady growth from Rs. 37,000 crore a few years ago means that there is merit in this category.
What’s the case for passive in thematic funds?
Firstly, like active large-cap funds, active thematic funds have also been underperforming their respective benchmarks. On a 3 year and 5-year average rolling returns basis, many actively managed thematic funds have underperformed the benchmark. The primary reason for underperformance is a smaller universe of stocks in such themes and the large chunk of companies within such themes falling into an increasingly well researched large-cap universe.
Secondly, unlike active funds, passive funds are true to label and have 100% thematic exposure to a stated theme such as healthcare, consumption, and financial services. Inactive thematic funds, 20 percent of the portfolio can be invested outside the theme as per SEBI guidelines, a provision active funds do use extensively.
Finally, some thematic funds also take global exposure which needs deep research and expertise. What is a Herculean task for funds which don’t have a physical presence outside India as it requires dedicated research teams and their expertise, can be easily accomplished via indexing which simply invests in stocks that are part of the index basis predetermined criteria.
Thematic funds are also not for everyone.
This is a category ideal for investors looking for a long-term strategic allocation to structurally strong themes. Moreover, investors looking for tactical allocation to capture mean reversions in performance – like bounce back after long-term underperformance in a sector – can look at this category. To take healthcare as an example, the theme has underperformed over the last 5 years and still has legs over the coming years.
Valuations are reasonable and the growth opportunity in the sector is attractive in the long run given rising healthcare awareness, rising lifestyle disease and the introduction of newer treatments. A healthcare index fund would be ideal in such a scenario to which can provide low cost, undiluted exposure to a healthcare theme. If global exposure of markets like the US which drives a lot of research/spends in this space is added, it makes the proposition more complete.
Of course, like every mutual fund, thematic funds (whether active or passive) too have inherent risks. They are not as correlated to broader markets, which means performance can diverge. Performance can be cyclical, with lulls of low returns. Investors either need to time the entry and exit intelligently or have long term strategic allocations where they can patiently ride out a cycle of volatility.
In the current scenario, along with diversified index funds, thematic index funds in beaten-down themes like healthcare, financial services and consumption can be interesting options for investors, given their risk appetite. The gamut of passive options is only expanding, and it’s a great time to be an investor!
Radhika Gupta is MD and CEO of Edelweiss Asset Management Limited
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