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

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

  1. Parag

    The article and the data analyzed present a very relevant feature of Mutual Fund investing. Over long runs Indexing has outperformed active management.

    The readers may wish to read book titled 'The Power of Passive Investing' by Richard Ferri.

    Reply
  2. bharat shah

    first let me confess that when i read the said comment , i found it thought provoking, and also your this post. but when most people are not fortunate having comfortable savings and so investments throughout the life , and have to try to maximize the wealth with their competence and knowledge through net etc., so even a little benefit would count. and for the decade (1-4-2000 to 31-03-2010) some good active funds 10 yrs CAGR average (: F.I.BLUECHIP HDFCTOP200 HDFC EQ. DSPBR EQ HDFCCAP. T.I.GROWTH F.I.PRIMA UTI MASTER VALU F.I.PRIMA+) as 22% v/s sensex CAGR 7%, and so the wealth multiplied is @7 times in case of good active funds v/s @3.5 times for sensex funds, that is almost double. i do not say that the same would repeat , and choosing good funds is easy, but it will definitely pay to be a little active , when direct equity is not our cup of tea.

    Reply
    1. pattu

      I don't disagree,. I think it will be difficult to get past returns because the entire market scenario seems to have changed today. The world is well connected with technology, FIIs plays a role. I don't think India will grow at a pace that it it. Returns aside, the key advantage of ETFs is diversification. With one large cap ETF, mid-cap ETF, I will have exposure to all kinds of stocks for a very low expense ratio.

      Reply
      1. bharat shah

        ' I don’t think India will grow at a pace that it it. ' that would be applicable to index funds too. the moot point, i think, whether the active mfs would keep giving CAGR some % age point higher return than the index funds in long run to justify their @1% -@2% point higher expense ratio. in last published report of Motilal Oswal wealth creation report , some 100 companies delivered higher CAGR than Sensex in 5 yrs period ended on 31st march, 2012. so there is hope to beat index by the active good funds.

        Reply
        1. pattu

          No argument here. Whether to go for ETFS or active funds is a personal choice. Personally I am a point in life where all I need from equity is 9% tax free. So I can happily move to ETFs.

          ETF investing has to be done intelligently too. The key to success is diversification, active or passive style.

          Reply
    2. bharat shah

      just one serious correction in my earlier comment: the sensex CAGR during the period is @13.36% , and not @7% as stated earlier. though the wealth multiplied is 3.5 times for sensex fund and 7 times for active good funds. sorry for error. thank you for your reply.

      Reply
    3. Jatin Visaria

      Bharat,

      Of course there are many funds which have delivered 22%+ CAGR in past 10-15yrs. And one should definitely invest in funds which will give highest possible CAGR over long period.

      However i have few questions...

      1. There are funds which have given 22%+ CAGR in past 10+ year. But real question is how many investors in those funds have captured this kind of return.

      Most of the investors will start investing in such funds after fund have achieved such return and not before achievement of such return. And to predict which fund is going to give such CAGR in future is not possible for the manager of that fund itself.

      Try finding out Asset Weighted Returns of these funds

      2. How many people knew before 10-12 years that these funds are going to deliver such CAGR.

      3. Who knows that which fund is going to give such a high CAGR for next 10yrs?

      With Index one is at least assured of market rate of return whatever it may be and can beat the inflation.

      Reply
    4. Favian George

      The point we should not forget is that you have selected funds by looking back...how does one select funds going forward. Future gains may not be same as the past for each of the successful funds.
      While we may think India is different from US, the Star fund Managers in US like David Swensen, Burton Malkiel and Charly Ellis keep harping that Index Funds (or ETFs) should be the only strategy and costs are the only definitive factor for fund performance...

      Read their latest book...
      http://www.amazon.com/The-Elements-Investing-Lessons-Investor/dp/1118484878

      Reply
      1. pattu

        Favian, as others have pointed out, there seems to be still some scope for investing in active funds in India. So as Jitendra has pointed out, well diversified portfolio with discipline is the only way out.

        Reply
        1. Favian George

          In theory yes there is scope to use active funds, but selection is based on historical data. If for example, I had invested in HDFC Top 200 as I did 4 years back, I would be stuck with 5% annual gains! While we may have faith in Prashant Jain and what he say about the fund picking up when the economy improves then it would do well. Do we want to wait another four years to find out? Today ICICI funds are doing well, so lets say I invest in some of them and five years later they fade away just like Top 200. We believe disciplined investments and churning will help, what if it doesn't?
          The arguments that fund managers use for India are the same for a developed market, so we should heed what the masters say! Mind you they have managed the largest mutual funds and hedge funds in the world and its 120 years of collective wisdom which say Alpha exists on in the short 3-5 years) term and not longer! Reliance funds earlier and now HDFC funds have proven it!
          The only reason we go for active funds is because there are very few Index or ETF funds...so we just need to stick to 4-5 star funds which are low cost, prefetably Direct Schemes. Till Index funds arrive in large numbers!

          Read here why active funds fail eventually..
          http://www.stayfinanciallyfree.com/#!passive-or-index-funds/c24hb

          Reply
    1. pattu

      Don't claim it is. I am aware that this debate is quite old. While the return factor is debatable at least in the Indian context, I don't mind paying a fee for a management that gives me returns by intelligent churning. The point of this post, is that i didn't recognise until Jatin made the aforementioned mentioned comment that I was paying a huge fee for not very active management.

      Reply
  3. Ravikiran Vadlamudi

    Wonderful article, just a quick question, Does the Index ETF's reflect the dividends given out by the Index stocks?
    As compared to the growth option of the mutual funds.

    Reply
    1. pattu

      I am not expert on ETFs. To my knowledge there are no divided payout ETFs. So I think dividends will be reinvested. Not an issues for equity funds. However for a liquid debt ETF like the liquidBees returns are reinvested after DDT. So I don't think it is a good option.

      Reply
    2. Jatin Visaria

      YEs Ravikiran, in case of ETFs also, dividends are reflected in NAV. However, generally ETFs should be at par with underlying Index level, to make that adjustment, AMCs pay out the dividend to investors. e.g. suppose Nifty Index is at 8000 point. Ideally an ETF which is 100th of Index should be priced at Rs. 80. However, if you notice this might not be the case & NAV of an ETF will be Rs. 83 or 84. This difference of Rs. 3 or 4 is due to dividend it gets from underlying stocks & expense ration charged to the fund. Now to take NAV of an ETF to level of Index, AMC may declare & pay out dividend of Rs. 3 or 4 to investors. Hope I am able to answer your query.

      Reply
  4. sunder

    friends, pl dont forget what has happened vis a vis reliance growth. seems same thing is happening with hdfc top 200/ dsp top 100/ dsp equity/ quantum long term equity fund. i hope they recover. but, i am not too sure. i am keeping my fingers crossed.

    Reply
    1. pattu

      Sunder, What happen to DSP top 100 and HDFC top 200 is not the same as what happen to Reliance growth. Both Top 100 and top 200 recovered well after the 2008 crash. I have not tracked top 100. In the case of top 200, Jain believes his stock picks will work when India comes out of this slump. So he stuck to SBI and the like, Did not go overboard on FMCG. This is admirable. Question is should I pay such a high expense ratio for this? Can I not do better with passive investing.

      QLTE is a good fund. It has done quite well, but it strays into liquid debt/cash and is too defensive. So it will miss market rallies. Unlike funds like ICICI blue chip or Birla frontline equity it does not churn too much, which is a good strategy. Personally I am sticking with top 200, top 100 and QLTE.

      Reply
  5. Pattabiraman Murari

    I am not expert on ETFs. To my knowledge there are no divided payout ETFs. So I think dividends will be reinvested. Not an issues for equity funds. However for a liquid debt ETF like the liquidBees returns are reinvested after DDT. So I don’t think it is a good option.

    Reply
  6. Sharad Singh

    Appreciate the insights and objective of the analysis.

    However, I differ on a few key propositions:

    The base assumption that managing index stocks should require the same fee as index ETF is incorrect in my opinion.

    Even by being 100% in Nifty stocks, a fund manager can generate alpha by appropriately weighting the right sectors and stocks (i.e. active weighting the portfolio). Funds don't necessarily generate alpha by investing outside the index/nifty/style.

    While ETF just requires replicating the index (and hence may be just operational costs), active management requires special skills, research etc (adding to significant costs) and hence fee.

    Of course, one should observe if a fund manager is delivering alpha on active funds and accordingly invest.

    Please feel free to point if I have missed something.

    Reply
    1. bharat shah

      i concur with the thoughts. any active mf would have some/large overlap with one or more of similar asset type index funds. but generating better returns on long term could be the job of the good active manager. it may happen that a good active fund may have all shares of this and that index fund. regarding expense ratio, i have impression that our mfs , both active and index funds have more compared to their western counterparts , and that may be because our inflationary economy , and less penetration of mfs as saving investment vehicles. i further think, the capturing good active mutual funds is comparatively easy than 10yr ago due to internet. even when you notice the AUM of good active mfs, it seems a lot of knowledgeable have captured them earlier. i have one more impression that the major indices have to include all major sectors' shares , irrespective of whether their prospects deteriorate due to govt. policies or any other reasons even for long term, whereas the active mf may avoid them altogether for betterment of return.

      Reply
  7. vignesh

    Pattu,

    Once again with the analysis opened my eyes.

    Always i was using quantum long term equity for my retiremnt savings.

    I will add a portion of passive investing via ETF also.

    thanks for the article.

    Regards
    Vignesh

    Reply
    1. pattu

      Hi Vignesh, Thanks. just ensure little overlap between QLTE and the ETF. Afterall diversification is more important.

      Reply
  8. Pattabiraman Murari

    HI Sharad, you know way more about this than I do. So all I can to is read and learn. I did think of some of the points you mentioned. If I am not wrong funds that have managed to stay afloat in the last few years, Birla Sunlife Frontline Equity, ICICI blue chip etc. have high churn ratios. So while one can beat the index by investing in index stocks in different proportion, investors have benefited from 'active; management and that is key. Alpha with high expense ratio (because of churning) is worth the price. As regards alpha and beating the market, trouble here is yardsticks differ not only from investor to investor (unsurprising) but from an expert to expert as well. So I would like to think why bother? Invest in the index and hope it delivers. We should all recognise that investment in active funds comes at a price: worrying about the fund performance. To me that is a bigger price to pay than fund management charges. Thanks for your views.

    Reply
    1. Sharad

      Sir, you are embarrassing me. In fact your diverse knowledge is impressive and I have thought quite a few times to meet you and discuss a few things... Possibly when I travel to Chennai or you are here 🙂

      Coming back to the point in this discussion:

      1. It's an investor's choice of active over ETF, but in either case he has to worry: while with index, he worries about absolute returns; with active he worries about alpha. The task is to be invested with discipline and choose the right active manager (additional headache).

      2. In my view, the market shall deliver good returns in the long term which makes the case for remaining invested.
      At the same time, there is enough scope for managers to deliver alpha and investors to reap that... So the additional headache is worth taking.

      3. A fund manager typically needs to churn his portfolio for appropriate positioning in various market scenarios, however that doesn't imply that higher churn might lead to higher alpha. So churn should not be a sole lever.

      4. Close to what we are discussing is something called 'portfolio overlap', which is the aggregation from security level of overlap wt in index and fund. So if fund has 3% in Infy against Nifty's 8% or vici-versa, overlap of this stock is 3%.
      This portfolio overlap stats might enrich the analysis above, though segregation of fee might still be an issue.
      1- portfolio overlap is the active weight that generates alpha (both from within and outside the index).

      5. One should also be wary in looking at how much the fund is going outside its index/style. Style impurity is not good.

      Yes that makes the entire stuff complicated for an investor, sadly that's how it is. Moreover, for regulator and other restrictions, we have just index ETFs. Ideally if we have some good strategy based ETFs, they might potentially deliver the returns if actively managed funds with a lesser fee.

      That investors' paradise is still quite a distance away.

      Regards,
      Sharad

      Reply
      1. pattu

        Many thanks for your detailed response Sharad.

        Hard to disagree with any of the points you made! The excel tool I used to calculate the table above gives the information of % of each stock. I should include this in the analysis. Without it would be, as you point out, incorrect to make conclusions on the fund managers actions.

        I think everyone should take note your comment carefully. Especially the fact that the whole process is not simple.
        This is the most crucial point. Most investors operate with scarps of information.

        I also agree with the other important point you, 'staying the course'. I would like to believe that even with a half-decent fund, the patient and disciplined investor should be able to beat inflation with a diversified portfolio.

        Would love to meet up with you and learn more about fundoo. I strongly believe there is a lot of potential in India for quant based investing. Each day 100s of investors are graduating from personal finance 101 thanks to blogs like Jagoinvestor and the rest.

        I think it is time people like you and a couple of other like minded individuals lend them a hand and say, 'I will help you invest provided you throw out your emotions'.

        Unfortunately I rarely travel out of Chennai. Do let me know if come to Chennai and we will meet up.

        Many thanks for your views.

        Reply
      2. bharat shah

        read your comments and pattu's reply , and found enlightening. thank you both of you.you stated 'Ideally if we have some good strategy based ETFs, they might potentially deliver the returns if actively managed funds with a lesser fee.' will you please elaborate the strategy you have in mind? does such etfs exist elsewhere? i appreciate pattu's advice that' I think everyone should take note your comment carefully. Especially the fact that the whole process is not simple.'
        and ' I would like to believe that even with a half-decent fund, the patient and disciplined investor should be able to beat inflation with a diversified portfolio.' thank you both again and hope you continue to enlighten the common investors like me

        Reply
    1. pattu

      Thanks Jatin. Do ETFs pay out dividends by default like dividend-option mutual funds? I know there are US ETFs which explicitly advertise this. However, I thought so far all Indian ETFs operated like growth-option mfs.

      Reply
  9. Jatin

    Let me give an example...suppose you have option to buy basic smart phone and advance smart phone. Basic smart phone comes in the range of 5K - 10K and advance smart phone comes in the range of 15K - 20K.

    Now in this case by paying almost double amount for advance smart phone you are 100% sure that you are going to get advance features like speed, display, performance etc.

    Cost is in direct relation with the experience you are going to get with that phone.

    But in case of Mutual Funds can you be 100% sure that by paying high fees you will be able to defiantly get higher returns or alpha ??

    Cost of the fund is nothing to do with the alpha. Beating index is pure luck. This time one beat the index...next time someone else will beat the index....and sadly the performances are measured in hindsight not in advance....

    Hope author is trying to convey same thing from this post...Please provide the feedback if the massage is different 🙂

    Reply
  10. Swapnil

    Can anyone elaborate if the ETF’s have any liquidity issues.I checked the IIFL Nifty ETF and it shows a paltry volume of 83.So if some one wants to buy/sell, he/she may not have any seller /buyer respectively on the other end or is there something I am missing? I do have limited knowledge of ETF's and that can lead to such trivial questions.I would appreciate if Pattu Sir and others can enlighten me on this…

    Reply
    1. pattu

      Hi Swapnil, you make a very interesting point. Search in google for "ETF volume difficult to sell". The first 3/4 hits are very interesting and seem to agree with you.

      Reply
  11. Ramesh

    I find a number of issues with this analysis.
    1. Comparison between an ETF (which comes with its own cost of buying and selling) with a regular mutual fund, and that too of the regular funds and not the Direct options? Why direct options - because you are doing a cost comparison. For comparison, IDFC Nifty fund could have been used.
    2. Some data issues. Morningstar shows turnover ratio of 53% with the IIFL Nifty fund (while IDFC's fund shows >250%). You can get the entire detailed portfolio of the funds at Morningstar instead of top 25 with VRO.
    3. It seems like the 'term' active management is considered to be either be away from the Nifty stocks (without any relation to the actual weights of the individual stocks) or do active churning.
    4. Passive management means having equal weightage of stocks with respect to the benchmark, both above or below the equal weight status means active management. So if Infosys is 8.9% in HDFC Top 200 while it is 7.7% in nifty, that means there is an active component of 1.2% with respect to Infosys, even with it being a Nifty stock. Same with Reliance being 7.3% in Nifty and 5.9% in HDFC Top 200 makes it an active component by 1.4%. This is for comparison sake, although, in proper sense there should be comparison with BSE200. So, active component is there even with the Nifty stocks within HDFC Top 200 and it is very wrong to assume that just because of the presence of the stock, that stock is being passively managed.
    5. Turnover ratio is not always the right way of active management. It should match with the conviction and analysis of the management team. DSP Top 100 works great with high churning while HDFC Top 200 and Franklin Blue chip work well with their low turnover ratio. A high or low turnover ratio just for the sake of it is wrong. These people do change at important times.
    6. ICICI Pru Focused Blue Chip fund has changed its manager even, so other things are not so important in that case.
    7. For the contended investor> what about the idea of buying and managing top 10-15 stocks from the nifty index and then check yearly or two-yearly. Top in the sense of lists like the Dogs of the Dow theory or some other parameter (low P/E or P/B or high dividend yield). The whole premise of a nifty index fund is to have large cap, low churning portfolio at low cost without putting any active management.

    Reply
    1. pattu

      Hi Ramesh,
      Agree will all your points.
      1. I did consider IDFC Nifty first. However I found that is not a replica of the index. So I went with cheapest ETF as a replica of the index. This brings me to your pt. 7. This idea is indeed interesting and Aditya who wrote a guest post here a couple of months ago is doing something close to this: be his own index fund manager.

      2. Yes I am are of the VRO limitations. I cannot retrieve the portfolio from morningstar (as yet) and it will be too cumbersome if I dont use a tool

      3 and 4. Point taken. Defintely a limitation. See also Sharads comments.

      5. Again point taken. Sometimes convictions beat benchmarks (FIBC is the bext exmaple I can think of) and sometime they don't. A related question is what is the length of the time I should wait for such a fund to change trends? Find it very difficult to answer this even quantitatively.

      6. Again in a quant analysis I cannot factor this in. Sometimes I wish I don't have to in any decision making. Unfortunatley I recognised that I have to.

      Reply
      1. Ramesh

        I will be interested in getting to know the strategy of Aditya.

        Regarding quant analysis of active funds, I have got this idea:
        1. For funds which are quite volatile, invest in them when they are marked as 3 star and remove money when they become 5 star. Being a 5 star is a time to run away, while a 3 star fund is great to have. This works in funds which have consistent management team and style.
        2. Or invest in solid 4 star funds which remain there only.
        3. If you listen much to the financial channels' recommended funds on personal finance topics and queries, the funds which come most frequently, be wary of them.

        Regarding HDFC Top 200 fund, I never invested in it in the past because it was considered the golden fund and a fund which could do no wrong. But now both HDFC Equity and HDFC Top 200 are great to have for the future. This should work on the simple assumptions of 'mean-reversion' and 'you make money during the bear phase, you just do not know it then'. A 5 star fund is a red herring for me.

        Reply
        1. pattu

          Please see Aditya comments here:
          http://freefincal.com/understanding-the-nature-of-stock-market-returns/

          I understand your point, Ramesh. However, I would like to think we have to come up with a simple plan with respect to mutual fund investing. I also think the onus of doing this is on people like who have some understanding of volatility and reversion to the mean.

          I think if an investor choose a fund which has performed in all market conditions and sticks to it through thick and thin (provided fund manager and investing philosophy does not change) he/she is bound to beat inflation comfortably in the long run.

          My point is whatever we choose to do or advice it must be simple and ETFs is a good way doing this. Stay invested and not worry about even the fund manager.

          Reply
          1. bharat shah

            just a thought. AVG BLOGGER, i think, Aditya, preferred GOLDMAN SACH CNX 500. do not 500 stocks make the over diversification ,which many experts advise avoiding?

          2. pattu

            First Goldman Sachs CNX 500 is an index fund and not an ETF. I think weights of individual stocks matter. CNX 500 have like any other equity fund more in financial stock.

            I buy equal weights of all sectors, then 50 stocks or 25 stocks should, I think, perform better than 500 stocks. Then it would be a case of over diversification. Not because of the number but because I keep buying stocks from the same category

          3. bharat shah

            whether etf or not , index funds are passive , and the expense ratio is supposed to be less than active funds. etf may have lower than normal index fund, it involves buy and sale expenses and in india, it seems problem with its liquidity. this is just for the discussion.

          4. pattu

            That is quite true. index funds should have lower expenses. Unfortunatley very few invest in them so it will not lower soon! So it is a catch 22 situation.

          5. Ramesh

            I checked that strategy. Seems like a combination of active (using Magic formula) + passive investing.

            I think the most important things for investing are:
            1. The attitude of frugality and live below your means. Unless this is there, no amount of investing will get you to remain comfortable in all types of economic environments in the future.
            2. The behavioral aspects of investing are paramount. Eg, how equity investments work and how they behave over different periods - unless an investor understands how these work, he/she will have difficulty in putting money in equities or will remove them on the first big burn. Or they need to follow someone whom they trust very much over long periods of time. The times of low or negative returns are very scary for most people. Subra provides that example to a lot of people including me. I remember his example of his father having kept money in Franklin Prima fund for decades and despite that being a mediocre performer, it still gave him around 18% CAGR returns (from memory).
            3. Passive investing is decent in highly efficient parts of the markets while active investing is better in the non-efficient parts. Active investing can be with focus on lowering beta (with zero or negative alpha) or increasing alpha (with same or lower beta). My preference is for lowered beta active investing. Passive investing is way too costly in our country (US vanguard gives 0.05% S&P500 exposure).

            The conviction in the plan with periodic reinforcements is what is important (of course, the plan itself should be statistically good). And summon the Lady Luck!

          6. pattu

            These are terrific points. I agree with all of them. Many thanks. I got the following response from a US financial planner. It is of interest to everyone:

            Your comments are a cause for concern across all time zones. I believe two issues matter here: One, Index Funds are reactive and portfolio managers are proactive (advantage active management). Two, the chart provided compares the expenses of a few select active and passive index funds, but not the performance of either one (advantage undetermined).

            Too many portfolio managers are compensated more for the size of their assets under management than for their performance (advantage index funds), but the index funds are market weighted owners of benchmark stocks that have been vetted and are owned by active managers, not the other way around. What investors in actively managed funds pay for is outperformance. This performance comes from the 5-20% of actively traded stocks that are not too widely owned or, more likely, mispriced (advantage active management).

            The solution to this conundrum is to change the fee structure. Perhaps a 100 basis point fee for the fund expenses (the vig) and another 100-200 basis points based on performance. This would separate the gifted portfolio managers from the mediocre ones and create more competition among the active money managers.

          7. Ramesh

            Hedge Funds are already doing that (a fee structure of 2 and 20%, in many cases). Quite a number of active managers have shifted to that only. So your last paragraph points to this.

  12. Arun

    Not sure if this point has been made already. One of the criticisms that I have heard of about passive index investing is the following. Because you follow the index, if a stock H enters the index, you tend to purchase when a stock H is at its peak (since the index is weighted by market cap). Similarly, when a stock L leaves the index (perhaps due to temporary poor performance), you sell L because the fund tracks the departure and is forced to sell. So seems to be a bit of buy-high and sell-low. Of course, if the index is stable for a long period, it might make sense to buy the index like many index funds seem to do in the USA. Not sure about how stable the indices are in India. In any case, Benchmark (now Goldman) AMC's USP is index funds.

    Reply
    1. pattu

      Hi Arun, That is indeed an interesting point. I know very little about ETFs so cannot comment on this. As far as I am concerned I only have one question. Why should I worry at such microscopic levels. If I wait long enough the index will eventually increase and give me a return which beat inflation. That is good enough for me.

      Reply
  13. Jitendra P.S.Solanki

    Hi Pattu,

    Well research article since long ETFs has still been lower in consideration of investors list. However, what holds for an investor is simplicity and diversification. Unless we have a long list of Index Based ETFs against actively managed funds, today its difficult to create an entire portfolio through it for a simple reason of diversification. Cannot put everything in a single ETF and cannot neglect active funds. My take is having a portfolio mix of these two should do well for investors.

    Reply
    1. pattu

      Hi Jitendra,
      Cannot agree you more that diversification is key. I also agree there should be more ETF choices available to the investor to be able to create diversified folios. Thanks for your views.

      Reply
  14. Favian George

    Today's high performance active fund is tomorrow's laggard! Look at the way HDFC Top 200 is going now with an AUM over 9000 crores! Now PruICICI funds are the darlings, earlier HDFC funds were! Can you predict which funds will do well in 5 years and we can all invest in those?

    Reply
  15. Favian George

    In theory yes there is scope to use active funds, but selection is based on historical data. If for example, I had invested in HDFC Top 200 as I did 4 years back, I would be stuck with 5% annual gains! While we may have faith in Prashant Jain and what he say about the fund picking up when the economy improves then it would do well. Do we want to wait another four years to find out? Today ICICI funds are doing well, so lets say I invest in some of them and five years later they fade away just like Top 200. We believe disciplined investments and churning will help, what if it doesn't?
    The arguments that fund managers use for India are the same for a developed market, so we should heed what the masters say! Mind you they have managed the largest mutual funds and hedge funds in the world and its 120 years of collective wisdom which say Alpha exists on in the short 3-5 years) term and not longer! Reliance funds earlier and now HDFC funds have proven it!
    The only reason we go for active funds is because there are very few Index or ETF funds...so we just need to stick to 4-5 star funds which are low cost, prefetably Direct Schemes. Till Index funds arrive in large numbers!

    Read here why active funds fail eventually.. http://www.stayfinanciallyfree.com/#!passive-or-index-funds/c24hb

    Reply
    1. pattu

      I partially agree with you. What would you do with more ETFs. I think there are enough ETFs available even now to build a well diversified portfolio.

      A 5% return over 5 year is bad for a say, 10 year goal. It is not unusual for a 20-25 year goal. Such is the nature of equity.

      Reply
      1. Favian George

        A 5% gain is the the nominal value; the real gains is minus inflation! That would be -4% a year. Its better to keep money is fixed deposits, post tax interest is more!

        ETFs are only available for Sensex, Nifty and Gold. What we need is ETFs in Mid Cap, Small Cap, Sector Funds, Commodities...in fact anything that has an Index. That's when one get true diversification.

        This is line with your other article on buying four assets (Stocks, Bonds, gold and another one, I forget) that gives Asset Allocation. In fact, true Asset Allocation where all Assets have little or no correlation gives the maximum gains over the long term. In fact 90% of gains come through Asset Allocation, not high performance funds that are like Shooting Stars that fade out in 5-8 years!

        Reply
        1. pattu

          Favian, I agree there is scope for more etfs. We do have a bank, small cap, G-sec and nifty junior etf.
          Even a well diversified ETF portfolio can give negative returns after 5 years.

          Reply
        2. Ramesh

          The 90% theory is completely wrong. Asset allocation is not that important at all. At best, a 50-70% correlation is reasonable during the accumulation phase of corpus building. During the distribution phase, the asset allocation factor decreases to 30-40% only. These are US based values. So whether they are directly applicable to a short-history market like India is pur conjecture.

          One has to look at various other things (behavioral aspects assume much more importance than pure mathematical averages based on past data) at different stages of money.

          You look confused to me about ETFs.. As Pattu pointed out, there are other midcap, bank, Shariah ETFs available. But their availability does not make for diversification. The more ETFs are available, more will be the active component for a portfolio.

          Active investing includes:
          1. Your asset mix (because that can be changed by the investor). Just because one is choosing passive index funds, does not make the portfolio passive.
          2. The frequency of rebalancing (again, an active component). And the range or fixed points of the rebalancing option.
          3. Choosing of an index ETF (and the underlying index). A nifty index fund behaves slightly differently than a junior nifty index fund.
          4. Different assets are not independent at all periods of time. During distress times, all asset classes start correlating with each other killing the benefits of diversification (eg 2007-8 crisis). There is no true diversification on this planet!

          The ideal passive indexer will just opt for 1 fund which will give exposure to entire world's stocks and bonds. Everything else is an active component and changes the overall return / risk of the portfolio.

          The entire debate about active and passive is based on the "relative" performance of different funds. In US markets, the vanguard funds are 4-star funds. While in India, the index funds are 3-star. That itself suggests a big no-no for India based index funds.

          Luck factor is a huge component (maybe 30-40%) of the total portfolio performance, and that has to be kept in mind.

          "Alpha exists only in 3-5 year periods." That is completely non-sense in my view.

          The concept of hot money is the problem. A simple rule of thumb is whenever you see the flow of hot money going into a particular direction, just run from there! Applies to every type of investment asset and funds.

          Reply
  16. Favian George

    You are right in the fact that mere existence of ETFs does not mean you get diversification! Just like buying 3-4 large cap or large-mid cap funds and expecting diversification.

    My points in case you did not understand were:
    1. You need ETFs that "don't have overlap"...pretty much like buying Regular Mutual Funds in a portfolio like (no overlap:
    - Quantum LT Equity (Large and Mid Cap)
    - ICICI Discovery (Small and Mid Cap)
    - Kotak Gold ETF
    - FT India Feeder Franklin US Opp (US Market)
    - ING Real Estate (Global Real Estate)

    There is almost no overlap except some maybe in the Midcap space.

    I am not recommending these funds but as an example of what Asset Allocation means. You are not tied to the Indian Equity market. This is true diversification

    2. If you get equivalent ETFs in India, then they would be low cost, 0.5% or less annual costs maybe.

    So the above would be ideal...full diversification, no concentrated bets, no "experts" who are no better than the average investor...and super low costs!

    Everybody has different definition of Asset Allocation and your choice how you want to define it...but unless you can convince yourself to stay in the market during downturns and jumping in when the market has gone up, no amount of logic is going to help! The biggest enemy to an investor is himself. Behavioural traits!!

    Reply
  17. Favian George

    You are right in the fact that mere existence of ETFs does not mean you get diversification! Just like buying 3-4 large cap or large-mid cap funds and expecting diversification.

    My points in case you did not understand were:
    1. You need ETFs that “don’t have overlap”…pretty much like buying Regular Mutual Funds in a portfolio like (no overlap:
    - Quantum LT Equity (Large and Mid Cap)
    - ICICI Discovery (Small and Mid Cap)
    - Kotak Gold ETF
    - FT India Feeder Franklin US Opp (US Market)
    - ING Real Estate (Global Real Estate)

    There is almost no overlap except some maybe in the Midcap space.

    I am not recommending these funds but as an example of what Asset Allocation means. You are not tied to the Indian Equity market. This is true diversification

    2. If you get equivalent ETFs in India, then they would be low cost, 0.5% or less annual costs maybe.

    So the above would be ideal…full diversification, no concentrated bets, no “experts” who are no better than the average investor…and super low costs!

    Everybody has different definition of Asset Allocation and your choice how you want to define it…but unless you can convince yourself to stay in the market during downturns and jumping in when the market has gone up, no amount of logic is going to help! The biggest enemy to an investor is himself. Behavioural traits!!

    Reply
  18. pattu

    Agree you with you. I agree with you that ETF choices are limited when compared to active funds but it is still possible to construct a decent enough folio with minimal overlap.

    Reply
  19. ashokan arunachalam

    ETF's are passively managed and I agree that cost wise ETF's far superior to actively managed schemes, having said that in India context I sincerely fee the volumes in ETF's have not grown, so practically it may be difficult for an investor to execute the transaction at his will. from the point of ease of executing transactions actively managed MF schemes may have an edge as on date, only time will prove in the coming days depending on the growth of the ETF's as a segment.

    Reply

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