Those interested in passive mutual funds—schemes whose portfolio mirrors their benchmark index— are thrilled by the Employees’ Provident Fund Organisation’s (EPFO) decision to invest in equities. This is because most of the EPFO investments in equities will be routed via passive mutual funds and, to attract EPFO investment, fund houses have begun cutting down expense ratios of their passive funds. SBI Mutual Fund started the trend by cutting the expense ratio of its exchange traded funds (ETFs) to 0.07%, leading to a significant build-up in its assets.
To stay in the competition, other fund houses have also started slashing their fee. While some have matched SBI’s low expense ratio, others have reduced it further. Since this is an emerging trend, it is only a question of time before remaining fund houses also cut their ETF’s expense ratio. Since employee provident funds managed by private trusts are also opening up to investment in open-ended funds, competition is stiffening in this space as well. UTI Nifty Index Fund, for instance, has already brought down its expense ratio to 0.10% for direct investors.
Should investors shift their mutual fund portfolio to these passively managed funds to benefit from the new low-cost regime? While the fall in the expense ratio is good news, investors also need to take into several other factors before investing in them.
Why passive funds?
“Actively managed funds are still outperforming indices and investors may continue to stick with these managed funds till this outperformance lasts,” says Kalpen Parekh, MD, IDFC MF. This is because the Indian capital market is not yet fully developed and, therefore, fund managers are able to spot better opportunities. Also, the lack of difference in the expense ratios of passive and actively managed funds has been another reason for the latter’s historical outperformance.
Index funds used to charge full expense ratio before the markets regulator, Sebi, prescribed lower expense ratios for passive funds. Now, the situation is changing on both counts. Not only have the expense ratios of index funds come down, the outperformance of actively managed funds has also been falling. The compound annual growth rate of a five-year actively managed fund holding ending in July 2007 was 11% compared to just about 2% for the past five years.
With the market sophistication improving, will actively managed funds continue to outperform in the future? While their outperformance may continue in the mid cap space, experts feel that this may not happen in the large-cap funds.
And that is why they advise you to consider passive funds for large-cap exposure. “Investors should allocate higher proportion of their large-cap exposure to passive funds now,” says Manoj Nagpal, CEO, Outlook Asia Capital. A significant portion of the outperformance by large-cap funds is generated by straying into the mid-cap space and smart investors can replicate it by taking exposure to mid-cap funds.
ETFs or index funds?
When going for passive investing you can either opt for exchange traded funds (ETFs) or open-ended index funds. “Since the negatives of ETFs are very high, it makes sense to go for open-ended funds in the current scenario,” says Nagpal. Deepak Shenoy, CEO, Capital Mind, a financial analytical firm concurs: “Open-ended index funds are a better bet now. There is no liquidity in most ETFs,” he says. For instance, no trading happened on 27 July in 13 out of the 59 ETFs listed on the NSE. High bid-ask spread—the gap between the price at which you can buy and sell units from the market—is a big problem facing ETFs.
Brokerage is another expense investors have keep in mind when opting for ETFs. “If you pay a brokerage of 0.50% at the time of buying and selling, this itself will add 1% to expenses,” says Nagpal. Also, ETFs are available only in the demat form and you have to consider the demat charges, if ETFs are your only holding. Due to these additional expenses, investors can’t compute the return from ETFs based on the change in their NAV. They have to do it based on their actual buy and sell price, after adjusting for the all costs involved.
Though index funds are free from the above mentioned problems, investors should not blindly invest in them. It is important to take into account the tracking error— the difference between the returns of the index fund and the benchmark index— when picking an index fund. Also, several funds charge 1% exit load, if redeemed in a short period, so, it is better to stick with funds with no exit load or those with a shorter holding period for the exit load to kick in.