Index funds are better for investors unsure about mutual fund scheme selection

Do you know how large-cap US mutual funds have performed over the past five years? Their track record is not very encouraging. According to the S&P Indices versus Active (SPIVA-US) report card 77.97% large cap funds underperformed S&P500 index over five years ended June 30, 2020! This is at a time when the US stock market has seen one of the biggest bull-run in its history.

This statistic can put off many investors looking at mutual funds to gain extra returns over the market returns. After all, the stock market, where equity mutual funds invest most of their corpus, is a go-to place for many looking for good returns, often outsized returns.

The recent multi-year rally in stocks had attracted many investors who harbored big wealth aspirations to equity markets. But only a few who dabble in stocks directly manage to create significant wealth in the long run. This is because of their lack of expertise in-stock selection. 

While a stock or two in their portfolio may run-up quickly, and some may end up as ‘multi-baggers’ in market parlance, sustainable solutions that multiply your investments over a long period become the need of the hour. Since diversified portfolios offer better risk-reward, many investors prefer the mutual fund route. While experts man the funds, they allow investors, big or small, to own diversified portfolios, which would otherwise be difficult given that many investors lack the time or skill, or both, to build, monitor, and realign diversified portfolios.

The onus of selection on investor

But mutual funds, especially those actively managed, like the large-cap funds mentioned above, come with their shortcomings. Actively managed funds are funds where the fund manager plays an active role in buying and selling stocks based on their analysis. In such funds, investors need to understand the philosophy or investment matrix adopted by the fund manager – growth, value, quality, momentum, volatility – in-stock selection. Not all of these approaches work in the market simultaneously. Even in bull markets, the performance of funds may differ from each other. So scheme selection, based on the stock-picking approach it employs, is a demanding task.

Even if an investor gets the scheme selection right, there is no assurance that you will end up outperforming the broad market or the index such as S&P 500. Often, a scheme that exceeds the index in a particular year fails to do so in the subsequent year. So, past performance is no guarantee for the future. Though some good actively managed equity funds keep beating their benchmark index, the costs involved may work against them. Outperformance to the index attracts a lot of new investments in the scheme, making it challenging for the fund manager to manage the flows and beat the index.

Fund manager’s role

This brings to the forefront what is called the ‘fund manager risk’. If the fund manager’s calls go wrong, it lends the fund open to the possibility of the actively managed equity fund’s performance being less than the returns offered by a fund that tracks the broad Index or an index fund.

As opposed to actively managed funds, index funds offer to mimic an index by purchasing all the constituent stocks in the same proportion that they are represented in the index. These indices are typically based on free-float market capitalization. It ensures that the stocks that the market participants favour keep getting more representation in the index as stock prices climb. In a way, the investment decisions are based on ‘market wisdom’. This ensures that the investor gets to pocket the index returns before costs and ‘tracking error’ or the slight divergence from the index performance due to certain factors. 

The tracking error may come as the fund manager may have to keep some cash in the portfolio to honor redemptions. Sometimes, underlying stocks’ illiquid nature may make it impossible to mimic the index in a live market. However, fund managers have found ways to keep the tracking error to the lowest possible over some time.

In a passively managed fund, such as Index funds, since the fund manager is not making any stock selection, there is no fund-manager risk.

On another front, in an actively managed fund, if a fund manager does well for a few years, the scheme’s fortunes get linked to her or him. If they quit for better opportunities, then investors have to track the successor’s performance again. If they do not find the successor worthy, they have to look for alternatives.

The cost factor

Actively managed funds generally charge higher fees than index funds. High charges make these funds an unattractive proposition when the extent of outperformance (excess returns offered by the fund over returns provided by the benchmark index) goes down. This is especially true if a particular fund gives lesser returns than the index for a few years in a row or offers only a small extra return over their benchmark index for many years. This makes it unattractive for investors to go for actively managed funds.

Also, given the nature of investment operation, index funds’ charges are mostly lower compared to an actively managed fund. These schemes are cost-efficient options to earn returns similar to that offered by the market. Instead of an open-ended index fund if the investor chooses an exchange traded fund or (ETF), the costs go down further.

Fund manager risks and high costs are severe obstacles for most long term investors in equity funds.

Fund houses too, have realized that the investors can be served better by offering cost-efficient Index fund products based on various indices. Initially, it all started with the broad market indices. However, over some time, asset managers have evolved, and so did index creating companies. 

In all stock markets, indices tracking broad market and the various sectors and segments are available. In multiple geographies, local indices have evolved. This has helped investors to benefit from diversification across market capitalization, as well as geographically. For example, an investor from the USA may want to invest in an index fund that tracks Hong Kong’s HangSeng Index or Indian Nifty index, or MSCI Emerging Market index.

Since index funds better address most average investors’ investment needs, they are gaining traction the world over.