Index mutual funds are doing better than others: Which type should you invest in?

Investor interest in index funds is growing. The main reason for this is the changing return profile of large-cap funds. Most large-cap funds have failed miserably over the past year in the face of stiff competition. However, the majority among those that have gained in this category are index funds—either open-ended or the exchange traded funds (ETF).

The falling expense ratio of index funds have also made them attractive. The expense ratio of several regular plans of index funds are as low as 20 bps to 30 bps. For direct plans, it is even lower. The emergence of more independent fee-based Sebi registered investment advisers (RIA) is yet another reason. Since they don’t receive any commissions, these RIAs have been recommending low-cost index funds to investors. Continued contribution by the Employees Provident Fund Organisation (EPFO) have also boosted the growth of index funds, with the total asset under management crossing the Rs 1 lakh crore mark.

Low expenses make index funds attractive
Opt for direct plans of the schemes if you want to reduce costs further.

Scheme Name	Corpus (Rs Cr.)	NAV (Rs)	Expense Ratio (%)	Tracking Error (%)
UTI Nifty Index Fund	1,076.28	70.71	0.20	0.10
IDFC Nifty Fund	139.40	22.42	0.27	0.12
HDFC Index Fund-Sensex	283.86	320.77	0.30	0.02
HDFC Index Fund-NIFTY 50 Plan	500.32	98.62	0.30	0.10
SBI Nifty Index Fund	342.19	93.22	0.65	0.10

Only schemes with at least Rs 100 crore AUM and tracking error less than 20 bps considered.
Source: Ace MF; Compiled by ETIG Database; Data as on 16 Jan

Experts feel this trend is here to stay. “It makes sense to go with index funds in the large-cap space. However, midcap fund managers are still generating alpha, so stick with them for the midand small-cap space,” says RIA Jitendra P. S. Solanki. Rohit Shah, Founder and CEO, Getting You Rich, concurs. “Unlike large-cap fund managers, midcap fund managers are still generating value for investors. However, it is becoming difficult, especially for midand small-cap schemes with very large AUMs,” he says. Non-availability of index funds of decent size in the mid- and small-cap space is one reason why most experts prefer recommending actively managed funds in this space.

Once you decide to go with index funds in the large-cap space, the next important step would be how to go about implementing it. Most schemes—open-ended index funds and ETFs—are based either on the Sensex or Nifty. For investors who want to go beyond these benchmark indices, the Nifty Next 50 Index is a good option. It has generated good returns in the past and a few index funds with decent AUM are also available here.

Two open-ended funds with AUM of over Rs 100 crore available are from ICICI Prudential and UTI and their expense ratio are between 80 bps to 100 bps. There are also several ETFs based on this index. “In addition to Nifty and Sensex based ETFs, liquidity is decent for several Nifty Next 50 as well,” says Ankur Kapur, Advisory Head, Banyn Capital. The next decision would be whether to go for open-ended index funds or ETFs. The main deciding factor will be the cost and convenience. If you compare expense ratios, index funds are slightly costlier than ETFs.

Lack of liquidity can be a problem in ETFs
In addition to low expense ratio, investors should also look at trading volume.

Scheme Name	Corpus (Rs Cr.)	NAV (Rs)	Expense Ratio (%)	Avg Turnover (Rs Lakh)
ICICI Pru Nifty ETF	1,018.04	113.31	0.05	56.39
SBI-ETF Nifty 50	42,708.39	110.72	0.07	79.57
SBI-ETF Sensex	13,623.99	381.20	0.07	10.43
Kotak Nifty ETF	618.16	111.58	0.10	89.31
Reliance ETF Nifty BeES	1,048.98	1,139.19	0.11	633.88

Sorted on the base of expense ratio. Only schemes with at least Rs 100 crore AUM and average daily turnover of Rs 10 lakh considered.
Source: Ace MF; Compiled by ETIG Database; Data as on 16 Jan

However, you need to consider all costs while buying and selling an ETF. For instance,while buying and selling an ETF. For instance, you have to pay brokerage at the time of buying and selling ETFs. The demant charges will be additional costs. “If you consider all related costs, the cost of open-ended index funds are reasonable”, says Shah.

Among the other factors that make index funds a better option for retail investors is its ability to set up SIPs easily. Since very few stock brokerages allow automated SIP type facility for buying ETFs regularly, ETFs are more suitable for investors who want to do it themselves. “Though expense ratio is slightly higher for index funds, it is worth it because of the convenience. Once investors start buying and selling themselves, ETF investors sometimes tend to trade also, which could be be harmful for long-term wealth creation”, says Solanki.

Lack of liquidity is a major issue with most ETFs in India. As of now, only a few ETFs have a large corpus and liquidity. The wide bid-ask spread (the gap between buysell quotes) is the next problem with most listed ETFs. Though one cannot predict the future, ETF investors should only get into schemes that have decent AUM and liquidity at present.

If you are working with a financial planner, working with index funds make more sense. This is because financial planners get details about your investments and redemptions automatically from AMCs through a mechanism called ‘reverse feed’. Since ETFs are held in demat form, this information is not available and therefore, investors have to download ETF details and give to their adviser at the time of portfolio review. “Since advisers don’t get reverse feed, it becomes difficult to do portfolio review automatically,” says Shah.