Last Updated on June 22, 2021 at 10:16 am
In this article, we discuss why it does not make sense to invest in an index fund that does not track the top 100 stocks or lesser weighted by market capitalization. In other words, not all index funds are the same!
We shall not discuss ETFs here as they come with their own problems of liquidity: large sustained deviations between price and NAV. See ETFs vs Index Funds: Stop assuming lower expenses equals higher returns! Also, the problems of tracking a large basket of stocks apply to ETFs too.
Let us take the one-year return difference (fund return minus index return) of different index funds (direct plan funds). This number will typically be negative (not always!). The Data presented here is sourced from the Index fund tracking error screener June 2021 and is as of June 11th 2021.
- Among five Sensex index funds: the lowest return difference is -0.46%. The next highest is -0.9% and above. Please note the more negative the number higher the deviation from the index (including dividends).
- Among 16 Nifty index funds: Only three funds managed to keep the return difference less than -0.5%; Eight funds between -0.5% to -1%; Four funds above -1% and one fund with +1% (it beat the index!).
- Among six Nifty Next 50 funds: only one fund with less than -1% and two funds with well above -2% return difference.
- Axis Nifty 100 Index Fund: -1.11%
- DSP Nifty 50 Equal Weight Index Fund: -1.03%
- The two Nifty 100 Equal-weight indices (From Sundaram and Principal; Soon to be one fund as Sundaram has acquired Principal) clock in well above -2.9% and -2.7%.
- Motilal Oswal Nifty 500 Index Fund: -1.88%
- Motilal Oswal Nifty Midcap 150 Index Fund: -3.1%
- Motilal Oswal Nifty Smallcap 250 Index Fund: -4.2%
Observations:
- As the number of stocks increases, the deviation from the index increases.
- If the weights become equal instead of determined by market cap tracking becomes difficult.
- A big difference between tracking 50 equal-weight stocks and tracking 100 equal-weight stocks.
- The deviations do not scale with the expense ratio. The average deviation for Nifty funds is about -0.7%. Motilal Oswal Nifty Smallcap 250 Index Fund has three times the expense ratio of a typical nifty fund, but its deviation is much larger.
Why does this occur? One reason is the poor liquidity of our markets. A way to understand this is via the impact cost. This is a measure of how difficult it is to buy or sell large quantities of stocks. If you wish to buy/sell a large quantity of a stock that is not frequently traded then there would be a bigger mismatch between buy and sell price. This results in deviations from the index.
If we look at the impact cost of the top 100 stocks by market capitalization on the NSE (published monthly) the bottom stocks have high impact costs. This is possibly why it is harder to manage a Nifty 100 equal weight index. A fund manager tracking Nifty 500 or the mid cap or small cap indices would end up buying a few stocks which no other fund house has purchased.
As long as the top 10/15 stocks dominate the weights, the deviation is reasonable. Up to Nifty 100, it is close to -1%. Beyond that, it rapidly increases. The ground reality is, there is no easy to “buy the entire market” passively without suffering loss. Much as the arguments presented in this article – The arithmetic of index investing explained – are enticing, they remain at the time of writing impractical to implement. I am not trying to say passive investing does not work; Just pointing out that venturing beyond Sensex/Nifty comes with a price and beyond the top 100, too high a price.
So what should investors do?
The following recommendations are based on the data available at the time of writing. If things change, then I am happy to change my opinion, but not before.
- Get rid of the idea that buying a larger slice of the market is different. You do not get 450 additional stocks by buying a Nifty 500 fund instead of a Nifty 50 fund. You get additional tracking error at a higher cost. See: Motilal Oswal Nifty 500 Fund: Avoid & stick to Nifty 50 Index funds
- Get rid of the idea that you are capturing different segments of the market by investing in midcap and smallcap index funds. No, you are not. You are just buying more cost and tracking error. A Nifty Next 50 Index fund is all you need to replicate these segments: guaranteed higher risk + potential higher reward:
- Does this mean I can invest in actively managed mid cap and small cap funds to capture returns from these segments? No! This idea of buying something different for something extra rarely comes good! Actively managed midcap and small cap fund struggle to beat the Nifty Next 50!
If you believe in passive investing then all you need is just one or two index funds (stay away from ETFs for long-term investing). A single Sensex or Nifty index fund will get the job done. Those who wish to venture beyond this (with the appreciation of what they are getting into) can consider a Nifty Next 50 Index fund. See: Combine Nifty & Nifty Next 50 funds to create large, mid cap index portfolios.