- Passive funds are not always safer
- Passive funds also underperform the index
- Tracking error and tracking difference in passive funds are not the same
New Delhi: Of late, more and more retail investors are getting attracted towards passive mutual fund schemes as actively managed funds have failed to outperform their benchmark over the last couple of years. Looking at the investors’ interest fund houses are lining up new ultra-low-cost index fund offerings. A few weeks back, Navi Mutual Fund created a buzz with its first offering—a Nifty50 index fund, which has an expense ratio of only 0.06%. Index funds simply try to mirror the performance of their underlying index by holding the same stocks in the same proportion in which the index holds. Despite this, index most funds fail to match the performance of the index they track.
Passive funds also have some drawbacks and advantages as well which investors should know before investing. Here are nine things investors should know about index funds and ETFs
Passive funds are not always safer
Many investors are of the opinion that index funds or ETFs are safer than actively managed funds. Worth mentioning here is that both active funds and passive funds invest in equities, which by nature are volatile. So if the market falls index funds will also fall in line with the index. However, as index funds track a particular index, the quantum of fall may be lesser than active funds in general. But both active and passive funds carry market risk and can fall if overall markets fall. But the only difference in case of index funds is that their risk profile is consistent with the underlying index.
Passive funds also underperform the index
Although index funds try to mirror the performance of an underlying index, in most cases they underperform their benchmark. Returns of a passive fund are usually slightly lesser than the index it tracks, for multiple reasons. “The index itself is a theoretical concept and replicating it comes at a cost,” ET Wealth quoted as saying Anil Ghelani, Head of Passive Investments & Products, DSP Investment Managers.
Worth mentioning here is that a fund’s NAV is arrived at after deducting expenses. So more the expense ratio of a passive fund, the more will be underperformance. The cash position held by the fund also contributes to the gap in performance. Also, inflows and outflows in the fund lead to divergences in performance. This apart, tracking difference may also arise during rebalancing.
A passive fund can also outperform its index
Sometimes, passive funds outperform their underlying index due to several reasons. Index funds having higher cash positions tend to outperform their index in case of market corrections. But if your fund is consistently outperforming its index—showing positive tracking difference then it is a matter of concern as it implies the fund manager is either struggling to mirror the changes in index or may even be taking unwarranted risk on the index portfolio. Experts say in a normal scenario, index funds are expected to show a nominal negative tracking error.
Tracking error and tracking difference are not the same
Most investors believe that tracking error and tracking difference of an index fund are the same. Typically investors use these two words interchangeably but these two are not the same. While tracking difference indicates the difference in return between an index fund and its benchmark index, tracking error signifies the volatility in the performance of the index fund relative to its index. tracking error is calculated by annualising the standard deviation of the tracking difference of an index fund. Tracking error captures the consistency in the fund’s tracking difference over a period of time. A high tracking error shows that the fund returns relative to its index keep varying widely and it is not a good sign.
Lowest expense ratio does not guarantee better returns
Typically investors tend to invest in the index fund that has the lowest expense ratio. But that does not guarantee better performance or lower tracking error. “Many other factors can still create a divergence between the fund and its index,” the publication quoted as saying Aashish Somaaiyaa, CEO, White Oak Capital. Funds with high expense ratios can also track the index better. And funds with low expense ratio may clock high tracking differences.
Obsessing over lowest cost index funds will be no different than yearning for highest return active funds. It traps you in the same endless pursuit. Just pick a fund with a reasonably low cost and stick with it for your investing time horizon, the publication mentioned.
There are additional costs in ETF other than expense ratio
Expense ratios of ETFs are even lower than index funds. But that does not mean that investors are better of buying ETFs. Unlike index funds, ETFs can be bought and sold on exchanges from other unitholders. So investors have to pay brokerage along with taxes and depository charges hile buying and selling ETF units from the market. These expenses increase the overall cost of holding ETFs.
Also, barring a few, trading volumes of most ETFs are very poor. This lack of liquidity often creates wide divergences between the fund NAV and the price at which it can be bought or sold. What you save in expense ratio is more than nullified by this impact cost. This gap is over and above the tracking difference common to both index funds and ETFs, the ET Wealth report mentioned.
Watch out for creeping expenses
At present, expense ratio of passive funds are low as they aim to attract more investors. But there could be a surprise later when asset management companies achieve their target AUM. Passive funds are currently in their infancy and are inviting more assets by keeping costs very low. Recently, several index funds hiked their expense ratios. Tata Sensex Index Fund’s expense ratio increased 16 times from 0.05% to 0.8% in early April. HDFC Nifty and HDFC Sensex index funds now cost twice as much – from 0.1% to 0.2%. Similarly, UTI Nifty Index fund will charge a TER of 0.18% compared to 0.1% earlier. All these hikes were on direct plan variant; the regular plans already charge higher, the ET Wealth report mentioned.
Bigger index doesn’t lead to greater diversification
Typically investors invest in passive funds that track a broader index such as Nifty 500 index to get the benefit of diversification. However, in real sense, this does not lead to greater diversification. Studies have shown that there is no incremental gain—in the form of lower risk—from diversifying beyond a point. In the same way, buying a broader index is not much different than buying a frontline index like Nifty50.
If you buy Nifty 100 index, theoretically, you do get 50 additional stocks but here the top 50 stocks enjoy a disproportionate allocation (84%) and the rest 50 stocks get lower allocation. So you don’t get the desired benefit of diversification. The equal-weighted index will allow for more diversification in the true sense.
Similarly, if you are investing in a passive fund that tracks Nifty 500 index, large-cap stocks, account for a whopping 77% of the index, mid-cap stocks constitute 16%, while small-cap stocks make up the remaining 7%. Index funds based on broad market indices like Nifty 500 may not actually offer the diversification that investors are looking for as these indices are top-heavy.
Funds tracking beyond frontline indices don’t track well
Of late many fund houses have launched passive funds tracking small cap and multi cap indices. But tapping the broader market with an index fund or ETF can come at a steep cost, the publication mentioned. It may be noted that the tracking difference get bigger for broader index-based funds.
According to the ET Wealth report, over the past year, the gap remains up to 1% for bulk of the Nifty 50-based funds. It rises to 1.5% and beyond for the Next 50 index variants. The return differential increases to 2% for the Nifty 500 index and widens further for funds that are based on mid-cap and small-cap indices.
The main reason for this is the poor liquidity in the broader market. The low liquidity increases the impact cost, or the cost of executing a transaction.