Should you invest in index funds?

It is evident why index funds have such a fan following in the US. When you have expense ratios in the region of 0.10%-0.20% of net assets and your returns are aligned to the index, which active funds in any case struggle to outperform, you have plenty of reasons to invest in index funds.

Cost-consciousness in fund management is an important trait in the US. Sample this, Fidelity's website mentions that it 'has contractually limited Fidelity Spartan 500 Index's total annual fund operating expenses (except interest, taxes, brokerage commissions, securities lending fees, or extraordinary expenses), as a percentage of average net assets, to be 0.10%.'

This means expense limit cannot be increased beyond the 0.10% limit without approval of the fund's shareholders and board of trustees.

But that is in the US; in India index funds have a long way to go before they can be considered inexpensive. Although, index funds are cheaper than their actively managed counterparts, the difference is not significant, which partly explains the lukewarm investor response.

When index funds do not make sense

It is apparent from the table that index funds in India have a lower expense ratio vis-à-vis their actively managed peers. Also apparent is that they aren't as cost-effective as their US counterparts when you begin comparing them to their actively managed counterparts from the same fund house.

Take FT India Sensex, with a low 1.00% expense ratio, it is still relatively high compared to Franklin Bluechip's 1.90%. Likewise, HDFC Sensex's expense ratio (1.50%) isn't that competitive when you consider that HDFC Equity's expense ratio is 2.02%.

In fact, HDFC Sensex expense ratio does not even compare favourably to HDFC Sensex Plus' expense ratio (1.50%), despite the fact that the latter has an element of active fund management to the extent of 20% of net assets.

If one looks at the index funds from the two fund houses we have selected - HDFC Mutual Fund and Franklin Templeton; at expense ratios of 1.50% and 1.00% (respectively), the disparity is too sharp, for the same fund management style. HDFC Mutual Fund's index funds are too expensive.

Of course, one has to also consider the fact that in India, many actively managed funds comfortably outperform the index over longer time frames (over 3 years). This is because unlike the US, India is a developing economy and many stocks are still under-researched.

This gives fund managers several investment opportunities to outperform the index. So investors chasing performance still have a good reason to invest in active funds. However, investors chasing lower costs do not have a good enough reason to invest in index funds.

In our view, index funds need to urgently address the issue of lower costs, because this can make a considerable difference to the total returns over a period of time.

This way index funds can be considered by cost conscious, medium risk investors; because even if their performance lags that of active funds, they can still manage to add a few percentage points of growth by way of lower costs.