Tuesday, March 13, 2012

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 Total Returns Index







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.


Index Fund




3 YR


5 YR


7 YR


Expenses (%)


Principal Index Fund








UTI Nifty Index Fund








Franklin India Index Fund








SBI Magnum Index Fund








ICICI Prudential Index Fund








HDFC Index Fund – Nifty Plan








Birla Sun Life Index Fund








LICMF Index Fund – Nifty Plan








Tata Index Fund-Nifty Plan








ING Large Cap Equity Fund








Canara Robeco Nifty Index Fund
















Nifty Total Returns








Goldman Sachs NIFTY BEES (ETF)







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 1/10th 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.


Hari said...


Thanks for sharing the information about Index funds in india, i am an NRI and looking to invest in india, i have 2 questions for you

1. Its not clear from the table in your post, which funds are tracking total returns ( including div ) and which are not. can you please clarify

2. You say you need to have Dmat account to invest in these Index funds, what are the options for someone who has no DMAT account, Can you please let me know


Nitin Goyal said...

1. I guess you are talking of non-ETF funds. To my knowledge, only HDFC Index Fund (both the Sensex and Nifty options) used to track the the total returns index of these indices earlier - however when I now check the details it seems they have been amended to track only the index.
Goldman Sachs SnP CNX fund does track the total returns, however it has a very high expense ratio of 1.5%. You can check this here : http://www.benchmarkfunds.com/gs/Documents/Factsheet.pdf

Do note that there are a wider variety of ETFs that do track total returns - GS Nifty BEES, IIFL Nifty ETF and Kotak Nifty ETF are among these funds.

2. If you do not have a demat account, you can still invest in mutual funds. However if you wish to invest in ETFs, you need a demat account.

Inquisitive Stranger said...

Hi Nitin,

How can we set up SIP in Nifty Bees, I called us GS and they said its not possible.

Nitin Goyal said...

For a SIP in NiftyBees, you need to go via the route of a Deamt account. Most trading platforms like ShareKhan, HDFC and ICICIDirect allow you to setup a SIP in stocks and ETFs of your choice. You can search the web for "Equity SIP IciciDirect" to see working examples.

Aditya Veera said...

Dear Nitin. Could an investor create a home-made index? Why not buy the cnx 100, cnx midcap & cnx small cap indices at equal weight, reinvest dividend and rebalance weights every year to avoid tax? What do you think of such a strategy; the cnx 100 data provided by NSE shows a significant increase of 2% return per year if you equal weight.

also, goldman cnx 500 is a bit of a rip-off due to high expense ratio, and the fact that the 400 companies below cnx 100 do not constitute a high % of your holding. Your thoughts?

Nitin Goyal said...

In my understanding, if you set up your own home made index, you have to "actively" manage by selling out companies that fall from the index and buying the others that get included. Maybe you can work this out for sensex which has 30 stocks or nifty which has 50 rather than cnx 100.

Equal weighing is fine in my opinion, but again, if you are really serious about indexing, you can look at funds like IIFLY Nifty ETF or IDFC Nifty which have an expense ratio of 0.25%. I think the brokerage itself is more than 0.25% in most cases if you are doing home made indexing.

I am happy to hear your thoughts or experiences on how this goes for you.

I agree with Goldman CNX500 - I think the expense ratio is too high and its not worth it - however I have two things in their favor as well :
1. They are one of the few funds that track the cnx500 total returns index and deliver - so yes they have a large expense ratio however atleast they give you index returns if not total returns. Most competitors dont even do that.
2. Since many of the cnx500 stocks are not very actively traded and managing a cnx500 index needs a lot of brokerage charges and rebalancing, higher costs than a Sensex index fund (30 stocks) are understandable, though still not justified.

Aditya Veera said...

Thanks Nitin. I can get brokerage far lower than .25% by using a company like Zerodha. By performing annual rebalancing, I avoid having to do those tasks too often (such as chucking out companies from the index, including new ones etc.)

The rationale is simple. Value-investing studies, time and again, have shown that there is no significant benefit to the investor of frequent rebalancing. What matters is the type of rebalancing - marketcap, P/E based or equal weight. Equal weight is a good balance between the growth & value investing styles (mkt cap does better if growth style succeeds; fundamental weight does better if value style succeeds).

Moreover, the tracking error is probably going to be 'cancelled out' over 20 years or so. Plus, the control you get over your dividends to reinvest them fully is important. More than one study has shown that dividend reinvestment is 50% of the total return of the S&P 500. Between 1900 to 2000, the S&P returned 5.1% capital gain compounded, and 5% dividend reinvestment compound addition to total return.

Aditya Veera said...

By the way, if you want a good discount broker, I recommend Zerodha. Your brokerage is Min(20,0.1%), so it can never exceed 0.1%. If you want, you can mention my name, and I will receive a reward for the referral. There are other good discount brokers too, depending on the frequency at which you trade. Zerodha is what I choose for indexing because there are no minimum trades or prepaid brokerage conditions.

We must consider Nitin, that the S&P 500 in US has good index funds at expense ratio ranging form 0.9% to 0.2%. That's 500 stocks. The Indian indices such as sensex have fewer stocks to buy. So where are those expenses coming from? They're eating up our dividends, because many investors don't insist on benchmarking to total return indices.

There may come a day when India offers ETFs and index funds which are truly low expense ratio and do a reasonable job of tracking total return. Until then, I think homemade ETFs disadvantages are outweighed by the very real advantage of being able to receive the full dividend & reinvesting it.

I wish I could attach a pdf here. There's a great study by Tweedy Browne that shows the effect of dividend reinvestment. the CAGR of S&P 500 from 1900 to 2000 in capital gain terms is 5.1%; with dividend reinvestment it becomes 10.1%. 1$ invested in 1900 grows to 190$ by 2000 in capital gain; 1$ invested in 1900 grows to 16,700$ with dividend reinvestment. And that's despite one great depression, 2 world wars, multiple small recessions, inflationary periods and the Cold War and wasteful expenditure on armaments.

Nitin Goyal said...


I agree with your point about dividends - they are an integral part of the returns and their compounding is what makes the difference.

The CNX 100 Index, as per http://www.nseindia.com/content/indices/Factsheet_CNX_100_EW_Index.pdf is rebalanced quarterly. If you plan to rebalance yearly, I am not sure of the impact on the tracking error. Even if you do end up rebalancing quarterly, I am not sure of the impact of capital gains - some stocks will increase while the others decrease in price.

The catch here from my perspective is :
1. There are index funds tracking NIFTY who are actually mirroring the total returns index at an expense ratio of 0.25% (like IIFL NIfty ETF or IDFC Nifty index fund). Are they worse than self made indexes?
2. Is CNX 100 equal weight index a better investment than Nifty?

Aditya Veera said...

If past returns are any indication, then yes, equal weight gives an extra 200 basis points to the compound annual growth rate returns.

Probably it is a good idea to do both the market-cap index and the ; I will look into the IIFL & IDFC options. Just curious, how are you judging whether they mirror the total returns well? I would like to learn the way to evaluate this.

Have you found good options to mirror CNX Midcap & CNX Smallcap? We cannot ignore the large academic literature which shows that size is correlated with returns (inversely). CNX Midcap at least seems to validate this, while CNX Smallcap is probably due for a boom due to the very low CAGR since inception which indicates market has beaten down the stocks.

I don't believe rebalancing has a huge impact in the long-run. In fact, judging by the past academic studies done, annual rebalancing could be just as good as quarterly. Not to mention it avoids tax. Even if there is a mild tracking error, does it really compare with the systematic depletion of dividend due to higher expense ratio? After all, to participate in small & midcap space, we are no longer talking about 0.25% but about 1% or 1.5% if you go for the non-direct NAV distributor option. And 1.5% is for very low exp ratio funds!

By the way, if you find good ETF / index options for small & midcaps, please let me know. I have only come across Junior Bees. Most 100 by Motilal Oswal looks ok, but I am unconvinced about their expertise in ETFs.

Nitin Goyal said...

Aditya - I am surprised that though you say you are in the game for 20 years, you feel that in the short term the small cap index is due for correction and hence is an opportunity. The way I see it is that in the long run all the indexes will fare more or less nearly the same, whether they are large cap, mid cap or small cap. Yes seasonal fluctuations are possible.

You can look at http://adm.valueresearchonline.com/pdf_live/get_fundcard.asp?sc=13382 for a snapshot of iifl nifty. Then you can compare total returns by visting the NSE website to get an indication of how this has been doing. If I check this today, IIFLY NIFTY ETF has given 17.32% in the last one year while NIFT has given 15.88%. The extra return is probably in line with the total return yield of NIFTY (to account for dividends). I did not validate the numbers from NSE site. The figure for IDFC Nifty is 16.79%.

The CNX Nifty Index represents about 65.87% of the free float market capitalization of the stocks listed on NSE as on December 31, 2012. Source - http://www.moneycontrol.com/nifty/nse/nifty-live

I am personally happy to go with 65& market rather than slice it on midcap and small cap as in the long run it should not be material. However I am not dismissing your thinking - its just that its not worth the effort it entails from my personal preference.

Aditya Veera said...

Nitin, in practice small cap and midcap indices do better than large cap indices. There is considerable long-term evidence of this. You can find it if you google for it. I respectfully disagree that all indices fare equally; to the best of my knowledge, this is not true.

Small cap has returned 8% CAGR since inception of CNX Small Cap. Midcap has returned 20%; NIFTY has returned 16-18% over many long-term periods. So small caps have catching up to do. It is because I have the patience and stomach for a long-term wait that I will put some allocation to small caps.

As for whether the effort is worth it, that depends. From market-cap nifty to equal weighted nifty adds 150 bp to the CAGR. From cap gain to dividend reinvestment adds 150 bp to CAGR. Total addition is 300 bp. Midcap premium is about 150 bp going by past 10 year data. So an equal weighted, dividend reinvested midcap 100 portfolio should yield nifty (cap gain only) cagr + 450 bp in the long run; ie. about 17% + 4.5% = 21.5%. What's the difference? 1 lakh invested at 17% yields 56 lakhs after 25 years; at 19% yields 77 lakhs; at 21% yields 117 lakhs. Worth the effort to some people :)I'd go with a 60% allocation to largecap, 40% allocation to midcap.

Having said that, I'm just discussing and do not mean to sound like a know-it-all. I find I learn a lot from disagreements in these discussions and I'm off to investigate your pointers like the IDFC Nifty. Thanks.

Nitin Goyal said...

Aditya: I just checked - I have a 0.15% Equity Delivery Brokerage, which inclusive of Service Tax etc comes to 0.18% (from ShareKhan). This translates to a brokerage of Rs. 180 for a trade of INR 1,00,000 which I would assume is cheaper than Zerodha in case you try to do large number of smaller trades.

Nitin Goyal said...

SO Aditya - how did it go for you - were you able to do this self indexing bit?

Anonymous said...


This is one of the excellent posts I have ever read on Index funds in India. I agree with your analysis wholeheartedly.

However I have a question. The dividend paying index funds are exchange traded. Apart from Nifty Bees, I did not see any volume of other ETFs. Even with Nifty Bees, the transaction volume per day is so low that I am worried if there would be buyers for these funds if I wish to sell on a particular day.

Perhaps I am not understanding how these should be transacted.

Nitin Goyal said...

I agree that NiftyBees and KotakNifty are actively traded funds on stock exchanges. Rest are not as actively traded.

It's what I think said...

Hello Nitin,

I am doing some research on index funds for my investment and I am looking for a long term investment though SIP (minimum 35 years). I have few queries regarding mutual funds and Index funds:

1) If a value research website shows a particular mutual fund has returned 12% over last 5 years, then what is effective return that an investor would get? 12% or 9.5% (12% - 2.5% expense ratio).

2) Morningstar shows 112% turnover ratio (and value research shows 40%) for IDFC Nifty fund. How can an index fund have such a large turnover ratio? Is there any error in that numbers. For many other fund I get different numbers on these two websites, whom to believe?

3) Many financial advisors on Internet are advising against index funds in India. Are there any basis for such advice or they are just protecting actively managed funds to earn higher commission.