Among mutual funds, index funds (a category of passive funds India), designed to passively mirror specific market indices, are favoured by investors for their straightforward approach to investing. Passive funds India replicate the index allocations.
While looking for index funds, or passive funds India, you might be shortlisting and comparing several schemes following the same index. So, it is safe to assume that different index funds tracking the same benchmark should deliver identical returns. But hard stop, the reality is different! Yet, the returns of the passive funds India differ across index funds schemes.
Various factors contribute to discrepancies in performance, even among index funds aiming to replicate the same index.
But why?! Let’s dive deeper.
Reasons for the differences in index funds’ performance
While aiming to replicate their respective indices, index funds (passive funds India) often face challenges in achieving perfect mirroring. Subtle distinctions between passive funds India, frequently overlooked, can significantly impact long-term returns. Though seemingly minor, these variations can compound over time, making it essential to carefully evaluate different index fund options tracking the same index.
One key factor is the expense ratio
Expense ratios play a crucial role in differentiating index fund performance. This is represented as a percentage of annual average assets under management, reflecting the fund’s operational costs. Simply put, the mutual funds house has to pay the fund manager and the AMC for portfolio management, in addition to the administration costs of documents, client support and so on.
For instance, Aditya Birla Sun Life Nifty Midcap 150 Index Fund Direct-Growth and Nippon India Nifty Midcap 150 Index Fund Direct-Growth have delivered returns of 22.77% and 22.48%, respectively, over a 3-year period (Data as of Oct 14, 2024 – link). While both funds track the same index – the Nifty Midcap 150 Index, their returns vary. Both funds’ expense ratios are 0.44% and 0.30%, respectively.
Although passive management in index funds typically implies lower expenses, variations still exist. Expenses are a key factor to consider as they directly affect an investor’s net return. A higher expense ratio means a lower portion of the corpus is invested, leading to lower returns.
As we saw in our example above, a fund can have a higher expense ratio and still have the potential to deliver superior returns. Same way, vice-versa is also possible. Motilal Oswal Nifty Midcap 150 Index Fund Direct-Growth has delivered a 22.76% return over a 3-year period, and this fund’s expense ratio stood at 0.30%. The returns are still higher than Nippon India Nifty Midcap 150 Index Fund Direct-Growth (22.48%).
That said, expense ratio should not be the only criterion for deciding on an index fund (or any other passive funds India).
Second, fee structure.
Fee structures further complicate the picture of passive investments in India, varying widely among index funds, even those with similar portfolios and strategies. Some funds impose entry and exit loads, which are charged upon investment and withdrawal. While SEBI has abolished entry loads for mutual funds in India, exit loads can still apply. Exit loads are charged if the amount is withdrawn before a predetermined time, usually 12 months. Do note that it varies with each fund or fund house.
For instance, the Nippon India Index Fund – Nifty 50 plan charges 0.25% as exit load to investors if the amount is withdrawn or switched before the completion of seven days of investing into the fund. Beyond the seven days, there is no exit load (link). Similarly, the HDFC Index Fund – BSE Sensex plan charges 0.25% as exit load if units are redeemed/switched out within three days from the date of allotment.
To be sure, these fees don’t directly impact fund returns but affect the investor’s final playout if they withdraw investments within the stipulated period.
Investors should holistically evaluate both the expense ratio and any applicable fees. An exit fee could offset a seemingly low expense ratio, impacting the overall return. Larger, more established funds often benefit from economies of scale, enabling them to charge lower fees. Funds with higher Assets Under Management (AUM) generally have lower expense ratios.
Third, tracking error.
Tracking error offers another metric for evaluating index investing funds and is also among the reasons for variations in returns among such funds.
Tracking error quantifies the deviation between the fund’s value and the tracked index, typically expressed as a standard deviation. Significant deviations indicate inconsistencies between the fund’s return and the benchmark. Several factors contribute to tracking errors, including:
- Cash balance of index funds: Mutual funds often hold a portion of their assets in cash or highly liquid debt instruments to manage redemptions or changes in index compositions. This cash balance can be 2%, 5% or more or less depending on the market conditions and the fund manager’s strategy for investable assets, thereby impacting tracking errors. Delays in reinvesting cash inflows from dividends or increased investments can also contribute to tracking errors.
- Challenges in buying/selling underlying index stocks: Low liquidity or sudden market movements can affect a fund’s ability to buy or sell underlying index stocks, particularly in sectoral or thematic funds, leading to larger tracking errors. Also, the fund or the AMC may not be able to acquire or sell the desired number of securities due to conditions prevailing in the market, such as circuit filters in the securities, liquidity and volatility in security prices.
- Rounding off of the quantity of shares in the underlying index.
- · Disinvestments by Scheme to meet redemptions, recurring expenses, etc.
Fourth, there are other charges.
The mutual fund house can charge its investors within the limits the regulator prescribed. These could include advisory fees, brokerage, transaction costs and more.
Beyond expense ratios, fees, and tracking errors, several other factors contribute to variations in returns among index funds tracking the same index:
- Fund turnover: The frequency of transactions (buying/selling) within a fund impact return. Higher turnover means higher fees, which can erode returns.
- Tax cost ratio: This ratio represents the reduction in a fund’s annualised return due to taxes paid by investors on distributions. Efficient tax planning can help maximise returns.
Wrapping Up
Achieving identical returns from different index funds tracking the same index is unlikely. Factors like expense ratios, fees, tracking errors, cash holdings, fund turnover, and tax all contribute to performance variations. Investors must carefully evaluate these factors to make informed decisions and choose the most suitable index fund for their investment goals. As always, the funds mentioned in the story are for information and illustrative purposes, and investors must consult a financial advisor before making any investments.
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