Index ETF vs. Large Cap Funds: The huge cost of ‘active’ management

Published: November 15, 2013 at 2:00 pm

How different is a large cap equity mutual fund from an exchange-traded fund (ETF) that tracks an equity index?  The portfolio of an index ETF is likely to be nearly identical to that of the index at any point of time.

Typically the portfolio of all large cap mutual funds will have a good amount of stocks found in any equity index  like Nifty/Sensex.

Quite a few large cap funds invest predominantly in index stocks. If the fund manager of such a large cap fund does not change the portfolio too much each year, should we not expect the expense ratio of the fund to be comparable to that of an index ETF?  Let us try to find out.

This post is inspired by Jatin Visaria’s following response to the Equity Mutual Fund Portfolio Comparison Tool

“If you compare HDFC Top 200 with say Nifty Index…in that case weight wise there is more than 75% overlap.  Now if you look at the expense ratio, generally index funds or index ETF charge around 1% where as actively managed funds charge around 2.5%.  It means to manage only 25% of your portfolio you are paying 150% more charges… I don’t know if its worth paying that much..”

Although the numbers he quotes are approximate, the weight they carry makes you stop and think. Insightful feedback from readers is the best reward for a blogger.

Here is a compilation of the expense ratios of several large cap funds compared with  IIFL Nifty ETF. The portfolio of the Nifty ETF can be safely assumed to resemble the Nifty at any given point of time.

The overlap between the large cap funds portfolio and the Nifty ETF is indicated along with the cost of managing stocks that are not part of the Nifty.  The overlap information was obtained with the Equity Mutual Fund Portfolio Comparison Tool using the portfolio listed at Value Research Online.

Index ETF vs. Large Cap Funds.

 Index ETF vs. Large Cap Funds

Note the extremely low expense ratio of the Nifty ETF.  The portfolio changes only by 12% in a year.  This should be approximately equal to the change in the list of Nifty stocks.

Now let us look at data HDFC Top 200.  Regular readers would know that I am invested in it. I have also posted a detailed analysis on HDFC Top 200 based on online data and based on rolling returns.

As on 30th Sep. 2013, a good 56% of HDFC Top 200 funds portfolio listed in VR Online can be found in the Nifty Index.

Top 200 ‘regular option has an expense ratio of 2.22%.

If I assume the cost of managing Nifty stocks is the same as that of the ETF (may not be true in reality, but is a justifiable from the investors point of view), nearly 88% of the expense ratio is paid for managing stocks that are not part of the Nifty.  Such stocks make up only about half the portfolio!

Assuming half the portfolio is filled with Nifty stocks, such a large expense ratio for managing the other half is justifiable if

  • The overall turnover ratio of the portfolio is high.  That is the  fund manager churns the portfolio with an aim of beating the benchmark (note: HDFC Top 200s benchmark is not the Nifty. It is BSE 200).
  • The churning has resulted in good returns

The turnover ratio of HDFC top 200 is only 23%.  As I have mentioned earlier, the long term performance of Top 200 is impressive.  However, considering that it is not ‘actively’ managed (relatively) should we pay such a high expense ratio?

The data is this table is strictly valid only for one month (Sep. 2013).  However if the trend continues for several months, it is definitely something to worry about.

One could argue that fund manager has conviction in his stock picks but then again a good number of stocks are likely to be part of the Nifty.  So why can’t I just choose a Nifty ETF and be done with it?

Literally, be done with it, for index investors never have to worry about the ‘performance’ of the fund manager.  All they need to do is to stay invested and hope that ‘long term’ market returns resemble the past.

If that happens, such investors are guaranteed to beat inflation: the only reason for investing in equity. If it does not happen, ETF investors are screwed. Can we say with confidence that under such circumstances, active fund managers will be able to?

If you look at the table, investors  in many other ‘active’ funds pay through their nose for managing a small part of the portfolio.

Funds from ICICI are a stand out in this regard, esp. ICICI Pru Focussed Blue Chip Equity.  The overlap with Nifty is small, the portfolio is churned quite a bit, and the fund manager’s actions are backed with performance.

The situation for ‘Direct’ mutual fund counterparts is a little better, only a little! HDFC Top 200 Fund ‘direct’ option has an expense ratio of 1.65%. A good 84% of the expense ratio is still used for managing non-nifty stocks.

Bottomline: The question to ask is,

are index ETFs better than actively managed large cap funds for long term financial goals?

I am now convinced that the answer is yes.

Index etfs ought to be the instrument of choice for the contended long-term investor, who has a clear idea about the kind of returns, needed for his/her long-term goals.

Nothing wrong with chasing returns by choosing active funds. However investors (like me) should be well aware of two burdens that their need to bear

  • the cost of choosing an actively managed fund
  • the dilemma of when to exit such funds when they underperform. Although tools exist to help in decision making, let us be very clear that it is difficult to get rid of this dilemma.

The way out:  Education: learning more about equity; understanding the difference between volatility and risk; understanding how compounding works in equity, and perhaps eventually graduating to passive investing via ETFs?

What are your impressions on this data?  Do you agree with my conclusions?

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