‘Very few fund managers can consistently beat the index'

We all assume that investors come to us so that we shoot the lights out! But a vast majority ofinvestors want just a bread-and-butter return that is substantially higher than other fixed-income options. Everyone wants to drive a Ferrari, but when it comes to driving on Indian roads, we all plump for a Maruti.

In an interview with Business Line, Mr Krishnamurthy Vijayan, IDBI Mutual's Managing Director and CEO makes a cast-iron case for why Indian investors should choose an index fund over so-called actively managed ones. He argues that beating the index is getting more difficult even for seasoned managers. The high churn in the mutual fund industry and the difficulty of predicting who will win make index funds the simplest solution for investors.

Excerpts from the interview:

Why has IDBI Mutual Fund started out with an index fund instead of an actively managed one? You were talking about the feasibility of having a wholly index-based fund house in India. Can you explain that?

It is my view that today, very very few fund managers are able to consistently add value to the index. A good number of fund houses have shut shop, moved on. Then, as the Indian market has become more and more efficient, the number of active funds outperforming the index is declining. The margin of outperformance too is diminishing.

We wanted to start off with a flagship Nifty fund because Nifty stocks account for around 60 per cent of the traded volumes. It provides sufficient diversification to investors, covering 50 stocks from 22 sectors. And the index itself is actively managed by competent people who apply liquidity and quality parameters to select the best of breed stocks.

Why should the investor settle for index returns, when some equity funds do much better?

Let's look at it this way. There are 64 fund houses that have, at various times, obtained mutual fund licences in India. Of those, about 22 have, in one way or another, exited the business. And of these, I would say only 4-5 funds have consistently delivered good returns. The rest have been mainly flashes in the pan — one good year, a couple of bad ones, and so on.

For the investor, this causes a lot of post-purchase dissonance. He buys a fund and sees the market going up, but his fund's NAV remains below Rs 10, sometimes for years. When the Indian market was in its early stages, a select club of individuals could make outsized returns based on information not generally available to the public.

As markets became more efficient, information came into the public domain, the disclosure rules also became more stringent. That still allowed room for professional managers to do better. But today, when there is a large mass of humanity armed with information, outperformance becomes very difficult.

For the investor, the dilemma is who is this person who is good enough to outperform that market? And am I willing to take the incremental risk required to get that outperformance? The average investor's answer would be ‘No'. When you can get a good average return that is superior to other options in the market such as debt instruments, that should be enough. Given that the index in India is consistently delivering a 20-25 per cent return, it thus makes sense to pick up an index fund.

Over the past few years, the proportion of active funds doing better than the index has been at 70-80 per cent. Only in 2009 did that drop to 60 per cent. Will active funds really find it difficult to do better than the index over the next few years?

My view is that not only will the incidence of underperformance continue, but that it will increase! First of all, even 60 per cent is not a great proportion. Two, these numbers are influenced by a survivorship bias, where funds that disappeared or have languished are simply not taken into account.

Three, research shows that, in any given year, the fund that gets the maximum fresh money is the top performing fund for the preceding year. Surprisingly, that fund is never the top performer over the next few years. Funds are typically able to make it to the top when they are tiny, but revert to mean when they become larger!

The category average returns that you see for equity funds are also misleading. Divide funds into quartiles based on returns and you will find that the index is looking much better than a good number of the active funds. Above all, we should look at what the investor wants. We always assume that the investor comes to us so that we shoot the lights out! But the fact is a vast majority of investors want just a bread-and-butter return that is substantially higher than prevailing fixed interest options. Everyone wants to drive a Ferrari, but who really buys one? When it comes to actually driving on Indian roads, we all plump for a Maruti!

I think the core portfolio of an investor only needs to be in bluechip stocks built up over a period of time. That is where an index comes into play. That is why every pension fund making a foray into a new market only takes an index exposure. Thirty or 40 years down the line, fund houses of today may not be around and neither will the fund managers, but the indices will still be around.

With SEBI trying to reduce the cost structure in the mutual fund business, there appears to be a shift to low-cost products. Are index funds also in line with this objective?

When there is very low premium to active management, the only way to deliver good returns to the investor is by reducing the management fee. By reducing the fee from 2.5 per cent (for active funds) to 1.5 per cent (for index funds), the investor gets an effective 40 per cent discount.

If you look at any diversified equity fund, about 70 per cent of the holdings are in index stocks. Where holdings are substantially outside the index, the funds don't weather market declines very well.

If investors need to buy the index, why not Exchange Traded Funds? Why have you used the open-end structure instead? Open-end index funds in India seem to have a very high tracking error.

The tracking error on Indian index funds has arisen largely because they either take cash calls or derivative calls and not because of their structure. You see, fund houses in India are psychologically active managers of money. The moment you take the leeway to be active, you tend to take on these calls.

To be completely passive, you need a lot of discipline. ETFs have a few disadvantages. One, today, the market for ETFs is quite small, as people like to buy from the issuer. The impact cost of buying an ETF (from the market) is high. Two, for a retail investor it is best to invest in the markets through a SIP, you can't do this in an ETF.

Three, upfront loads have been banned on mutual fund products. Yet while buying an ETF you will be paying an upfront brokerage. Internally, we have set a guideline that the tracking error on the IDBI Nifty Index Fund should be less than 1 per cent on the Nifty. We are also consciously adopting the Nifty Total Returns index as our official benchmark to factor in dividends.

Source: http://www.thehindubusinessline.com/iw/2010/05/23/stories/2010052350600700.htm