Should you buy an equity fund where the fund manager actively chooses stocks or go with a fund that just invests in the index?

This question is a valid one after the last few years of turbulence and the struggle by equity funds to deliver market-beating returns. The answer depends on whether actively managed funds do beat their benchmark over the medium and long term.

Room for both

So here’s the good news. Over two-thirds of equity funds in India (leaving out the ones that invest in fancy themes or sectors) have beaten their own benchmarks over the last three- and five-year periods. That means you have a reasonably large universe of outperformers.

Still, index funds can form a part of your portfolio for the following reasons: one, given the large universe of equity funds, it is quite possible that the funds in your portfolio turn out to be underperformers unless you are an astute investor.

There have been some periods — the last one year, and the three years between August 2006 and 2009, for instance, — when half of diversified equity funds have lagged their benchmarks.

It, therefore, makes sense for you to own at least some funds that replicate the index.

Two, as the fund industry in India does see frequent churn in managers, investing in an actively managed fund involves taking a ‘fund manager’ risk besides market risk.

If you are not game for this, then index funds will simply allow you to take risks related to the market alone.

Three, even if you do take on additional risk to earn index-beating returns, you may not beat the index by a mile.

While top funds beat indices by over 10 percentage points, the category managed only a 4-5 percentage-point outperformance, whenever they beat their indices over one- three- and five-year time frames.

underperformance

The average returns of about 200 diversified equity funds (excluding theme funds and tax-saving funds) over the last one year ending August 24 were 7.2 per cent.

That is lower than the 9.2 per cent and 10.1 per cent gain witnessed by bellwether indices Sensex and Nifty, respectively.

Over this period, only one half of this fund universe beat their respective benchmarks. Even well-established funds such as Franklin India Bluechip or HDFC Top 200 marginally lagged their respective indices.

But the picture is more comforting over a longer period. Over 70 per cent of the funds outperformed their benchmarks over a three-year period of August 2009-12, while two-thirds outperformed over the last five years.

What pulls them down

The present one, three- and five-year performance of funds appears to suggest that fund managers may falter in the short term but do get it right over longer terms. Take the case of long-term outperformer HDFC Equity. This fund beat its benchmark S&P CNX 500 in the 2009 rally and also contained declines well in the 2011 fall and has a good five-year record.

But in swift rallies such as the one in 2007 and the one in 2012 this far, it lost out. Often times, this could be because the fund held low exposure to a certain segment of the market that rallied. The 2012 rally, for instance, was driven by mid-cap stocks but HDFC Equity held a majority in large-caps.

In certain other cases, the underperformance could be due to a fund turning cautious and holding more in cash. IDFC Imperial Equity is an example where the fund held just about two-thirds in equity when the markets rallied from the March 2009 lows.

It was at least almost five-six months before the fund upped its equity holdings to over 90 per cent, thus missing out on the initial run-up.

long-term hiccups

Yes, funds have fared much better over a three and five-year time frame now. But that has not always been the case.

Take the period between August 2006 and 2009: only 47 per cent of the equity diversified funds then beat their benchmark (between August 2009-12, 72 per cent outperformed). Some of the current top funds such as ICICI Pru Discovery or Reliance Equity Opportunities lagged their respective benchmark over August 2006-09, although they outperformed in the subsequent three years ending August 2012.

Clearly the 2008 downfall had done the damage despite the previous year’s rally when diversified funds as a category beat key indices such as Sensex and Nifty by a good 10-15 percentage points.

Holding the index

But good fund picking and monitoring can make a huge difference to your portfolio returns. Even in the last one year of volatility, at least 25 funds beat their benchmarks by anywhere between 7 and 18 percentage points.

But if you wish to hedge your portfolio from the risk of your funds falling in the bottom quartile of the chart, then index funds are a good bet.

You can hold 15-25 per cent of your portfolio in index funds based on your risk appetite. Should you choose index funds or ETFs for this purpose?

While both can have tracking errors and do charge expenses, ETFs have proved to be more volatile, as a result of being traded in the market. Over three and five years, the average returns of index funds and ETFs (based on market price) were almost the same.

As you can buy ETFs only at market prices and not NAVs, we looked at the market price returns of ETFs.

Unless you are a close tracker of the market and want to time your entries to a nicety (through ETF), index funds should do well for your passive investing needs.

>vidya.bala@thehindu.co.in

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