Sunday, February 05, 2006

 

Shooting For Average : Index funds in your portfolio


Index funds are well-known for their advantages: low expenses, passive management, and, in most cases, zero loads. Index funds shoot for average performance at low cost. While most index funds in the US track broad indices, such as the S&P500 or the Wilshire 5000, Indian index funds track either the 30-stock Sensex or the 50-stock Nifty. These narrow indices represent the bluest of the Indian blue-chips but are too small to represent the entire market. My argument is that, given these narrow indices, an investor should look at index funds as the replacement of the large-cap part of his or her portfolio.

Lake Wobegon

Figure 1 shows the number of funds outperforming the Sensex each year since 1997.
If 90% of mutual funds can outperform the Sensex for three years running, the Sensex is not the average. Either that, or we have the change the definition of average.




Figure 1: >90% MFs beat the Sensex in 2002-2004

Looking at the best-performing mutual funds for the trailing year shown in Table 1, we can see that the average large-cap holding of the mutual funds is 38.20% and that the average capitalization of the companies in the portfolio is ~Rs.5000Cr. Compare this with the average capitalization of the index stocks of Rs30,000Cr (Sensex) and Rs.27,000Cr (Nifty). The average capitalization of the companies that these funds invest in is less than 1/5th of that of the index stocks.


FUND NAME

Average Market Cap (Rs.Cr)

% in Large Caps (2005)

1-year returns(trailing)

Sensex

~33000

100.00%

47.17

Nifty

~27000

100.00%

41.41

Magnum Emerging Businesses

1249.28

8.00%

80.21

Magnum Global

1219.11

5.00%

86.78

Magnum Multiplier Plus

5088.72

50.00%

83.24

Prudential ICICI Emerging STAR

856.07

0.00%

83.15

Magnum Contra

5293.63

55.00%

78.88

Reliance Growth

3210.94

34.00%

73.97

Bonanza Exclusive Growth

7156.14

56.00%

73.61

HDFC Core & Satellite

7552.52

57.00%

72.63

Sundaram India Leadership

5631.47

47.00%

72.23

HDFC Equity

14059.88

70.00%

71.41

Average

5131.78

38.20%

77.61


Table 1: Best performing funds (1-year trailing)


Making the right comparison

But what about active mutual funds that are fishing in the same pond as these indices? It would seem logical that, with the weight of professional management behind them, mutual funds investing in large-cap companies would outperform the indices. Table 2 shows the performance of mutual funds with the highest proportion of large caps in their portfolio.


FUND NAMEAverage Market Cap (Rs.Cr)
% in Large Caps (2005)1-year returns (trailing)
Sensex~33000100.00%47.17
Nifty~27000100.00%41.41
UTI Index Select Equity44817.7995.00%42.43
ING Vysya Nifty Plus40848.1899.00%36.26
Can D'Mat34529.66100.00%62.51
HDFC Index Sensex Plus32157.9194.00%48.68
LICMF Sensex Advantage31037.1794.00%43.91
UTI Large Cap27345.4993.00%35.4
DSPML Top 100 Equity27339.4996.00%52.11
UTI PSU24023.0585.00%31.5
BirlaSun Life Frontline Equity22355.7679.00%49.12
Cangrowth Plus21769.1384.00%59.6
Average30622.3691.90%46.15

Table 2: Large-cap mutual funds (1-year trailing)


The results are not very encouraging. The returns are not bad but are a far cry from the 70% return of the best funds. The average return of these mutual funds is less than that of the Sensex (and we haven't even added in the entry and exit loads yet!). Also, note that some funds trying to beat the index using the stocks of the index (LICMF, UTI, ING) are underperforming their respective indices. It seems to me is that an index fund is a better bet than one of these large-cap funds.

Using an index fund

If an investor just chooses the funds with the best past returns, he or she will be overweight on small-cap and mid-caps stocks. An approach that could work is to take care of the large-cap representation with an index fund first. This leaves the investor free to choose a basket of funds that invest exclusively in small-caps and mid-caps to top off the portfolio.



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