Why Costs and Tracking Error Are Not the Only Key Items for Choosing a Suitable Index Fund.

There are many Index Funds available in the Indian market that tack the Major Indices like S&P CnX Nifty and the BSE Sensex. Typically investors end up choosing the fund with the lowest expense ratio and tracking error. However I would here try to illustrate that these are not sufficient by themselves to help make you make the best informed choice.

Index Funds are a good bet for a long term investor so if you are looking at short term trading tips or gains using them then this article is not going to offer much help.

The index funds buy and sell individual stocks in the same proportion as the underlying Index. Over a period of time these individual stocks declare dividends which can be accumulated over time and invested back in the underlying index. This is the concept of the “Total Returns Index” which basically reinvests all the declared dividends in the index. As an example for the Nifty the Total Returns Index data is as below (source here) :

NIFTY Index
30-Jun-99	1187.7
1-Mar-12	5339.8
Return:	12.59%
NIFTY Total Returns Index
30-Jun-99	1256.4
1-Mar-12	6780.6
Return:	14.22%

A simpler way to understand this is that if all the dividends declared in the companies comprising the Nifty were reinvested in Nifty itself from 30-Jun-99 to 1-Mar-2012, the value of the Nifty would have been 6409.8 (which is 1187.7*6870.6/1256.4) instead of 5339.8. We seem to be getting a dividend yield of nearly 1.63% over the long term in the Nifty.

While an investor looks at the expense ratios and tracking errors of index funds, somehow this aspect of dividends and total returns is totally ignored in the decision making process. In order to highlight this further, I have taken the performance for all index funds launched before 2005 tracking the Nifty to be able to take a long term view of their performance. All data is as on 7 March 2012 using Value Research.

No.	Index Fund	Index	Launch Date	3 YR return	5 YR return	7 YR return	Expenses (%)
1	Principal Index Fund	NIFTY	Jul-99	25.23	6.57	12.10	1.00
2	UTI Nifty Index Fund	NIFTY	Mar-00	25.10	6.88	13.21	1.50
3	Franklin India Index Fund	NIFTY	Jun-00	25.72	7.27	13.54	1.00
4	SBI Magnum Index Fund	NIFTY	Dec-01	25.70	6.05	12.28	1.50
5	ICICI Prudential Index Fund	NIFTY	Feb-02	26.35	8.68	15.11	1.50
6	HDFC Index Fund – Nifty Plan	NIFTY	Jul-02	23.76	4.72	11.20	1.00
7	Birla Sun Life Index Fund	NIFTY	Sep-02	25.00	6.78	12.83	1.50
8	LICMF Index Fund – Nifty Plan	NIFTY	Nov-02	24.70	5.19	11.08	1.19
9	Tata Index Fund-Nifty Plan	NIFTY	Feb-03	25.20	6.61	13.97	1.50
10	ING Large Cap Equity Fund	NIFTY	Jan-04	25.15	6.82	12.74	2.50
11	Canara Robeco Nifty Index Fund	NIFTY	Sep-04	25.36	7.22	12.86	1.00
12	Nifty	NA	NA	25.83	7.54	13.44	NA
13	Nifty Total Returns	NIFTY	NA	27.08	8.72	14.85	NA
14	Goldman Sachs NIFTY BEES (ETF)	NIFTY	Dec-01	26.66	8.37	14.46	0.5

Let me make some observations on the data above:

• Most of the index funds are not even able to match the performance of the Nifty. (I will discuss the special case of ICICI Prudential later.)
• In addition to collecting the expense ratios which are very high, the funds are coolly pocketing the dividends as well since they are falling behind the index. I do understand there is a need for the funds to keep some cash and there are trading costs, but the numbers speak for themselves.
• To my knowledge HDFC Index Fund is benchmarked to the Nifty Total Returns Index, not the Nifty but it is not even able to match Nifty in any period.
• ICICI Prudential Index Fund seems to be outperforming the Nifty – even the Total Returns index in-spite of having a very high expense ratio. I would be very skeptical of investing in this fund as this seems to be an actively managed fund.
• The ETFs like GS Bees, Kotak Nifty are benchmarked to Nifty total returns, not just Nifty. As a case in point GS BeeS regularly declares dividends as over a period of time the accumulated dividends make the NAV higher than 1/10^th of Nifty. In case of Kotak Nifty and Kotak Sensex fund, the dividends are accumulated and so the NAV of these funds are higher than that of the underlying units by a small margin. See below (source here)

So to summarize:

• Look at the dividends angle (by checking if your fund is benchmarked to total returns index and is delivering as promised.
• Ensure you have lower costs and tracking errors.
• You may be better off with a fund tracking Nifty total return index having a higher expense ratio than a fund tracking just the Nifty with a lower expense ratio.

If you are investing in an ETF, you require a Demat account. Additionally you are required to pay brokerage charges while buying and selling these. These charges are over and above the expense ratios of these funds.

For various reasons these index funds have not picked up well in the Indian market unlike the west, and Manshu does make some valid points on this aspect.

* I have used the data from June 1999 as that’s the one available on NSE website for Total Returns Index.