Wednesday January 18, 2023

Index funds, the new game on Dalal Street

Author: Adit Jain,Editorial Director, IMA India

Fund Managers are at the upper end of the income spectrum, amongst professionals within the finance industry and with good reason. They have obligations to manage huge sums of money entrusted to them by institutions and small savers. Their benchmarks are really quite simple. They have to beat each other and, in the bare minimum, the stock index – which is something they generally manage. The reasons are clear. Fund managers have inroads into companies and their CFOs, the skill sets to analyse performance and business outlook, and consequently the aptitude to take a punt on what they consider winners. But as markets become more transparent with improved pricing efficiencies, this will change.

In the United States it already has, as money has moved consistently from funds that try and beat the market, to index linked or exchange traded ones. Funds that track broad US equity indices have touched USD 4.3 trillion in September 2019 against USD 4.2 trillion in those that are actively managed. This is one of the most histrionic changes that have occurred within the financial economy.

The shift has lowered the price of investing for individuals and businesses, reduced the influence of stock pickers and, as some would argue, brought about a fairer market place. Index funds are cheap to manage and the fees charged by managers are a tiny fraction of a per cent. They tend to be five times higher for actively managed ones. On the flip side however, there are understandable concerns that market mimicking could distort prices and aggravate market turbulence in the event say of a massive sell-off. Interestingly, in the United States, more than 80% of the actively managed funds underperformed the market in the decade from 2008 to 2018 and investors complained of a rip-off due to their exorbitant fees, coupled with underwhelming scores.

Exchange traded funds (ETF) that emerged in the 1990s, are a collection of stocks and bonds like index funds, but trade on exchanges and give investors rapid exposures to markets. Within India, they come with tax advantages. ETFs incur capital gains taxes only when they are sold. Moreover, ETFs are easy to buy and sell, unlike redemptions in a mutual fund, which can be complicated. They are also transparent and simple to understand unlike conventional funds that often indulge in changes in strategy or composition requiring investors to constantly remain on the alert. Most significantly, the expense ratio in an ETF can be as low as 0.04%, whilst mutual funds charge around 1.5-2.5%, especially in the equity category.

As investor interests shift from actively managed to index linked funds, this will bring about structural changes in the financial markets. Companies that are a part of an index will more easily attract capital and therefore be prone to swings within the market place. Large index funds would eventually hold a substantial chunk of equity in companies, which would give them enormous influence over management, creating governance challenges. Moreover, given the large universe they invest in, their teams may simply not have the bandwidth to scrutinise every company and sector specific issue.

That aside, index funds will gain popularity in the years ahead as markets become more transparent and investors more cost conscious. Bharat Bond 22 ETF (a fund of 22 public sector companies) has been launched to a remarkably good reception due to its stock selection, good corporate governance and very low expense ratios (0.01%). This will, analysts believe, enhance the pace of transformation from actively managed funds to index linked ones, as well as the lopsided pay structures that the few privileged currently enjoy.