Why returns of index funds vary from its index & Other similar funds

Introduction:

Index Mutual Funds invests in stocks resembling underlying indexes. For example, a Nifty 50 index fund invests in stocks in the same proportion of its underlying index. Here one may conclude that returns of all index funds underlying the same index should be the same. But the same is not true when it comes to reality. Though the difference will not be huge, a considerable amount of difference exists between similar index funds of various AMCs. This article covers differences between returns of popular index funds, reasons for such differences, and points to be kept in mind while selecting an index fund for investment.

Differences in returns:

There are various types of indices based on which index funds are being constructed. Popular indices when it comes to the context of the Indian market are Sensex, Nifty 50. This article covers differences between index funds of these two indices. The below table summarizes differences as mentioned above:

From the above table, we can conclude that differences between its benchmark are not as huge as requiring in-depth attention but just requires attention while selecting a mutual fund.

Reasons for such differences:

There are various reasons for such differences with benchmark return. Few common points are summarized below:

• Expense Ratio:

Index funds are Passive Mutual Funds (refers to a fund that tracks a market index to allow a fund to fetch maximum gains. Fund Manager will not actively choose what stocks to buy/sell and at what quantities. Since the fund manager will not involve actively in active buying & selling, the corresponding fee will be lower. Fund Manager’s fee is one of the major expenses for a Mutual Fund. Since this fee will be low, the expense ratio will be very less. Investing in funds having High AUM (Assets Under Management) is considered better since the expense ratio of the same will be less. AUM & Expense Ratio of above-mentioned funds are tabulated below:

From the above table, we can come to a conclusion that funds having higher AUMs are having a very low expense ratio. The impact of expense ratio on investment is discussed in the previous article in detail.

• Entry & Exit Loads:

These loads are charged upon investment & withdrawal of investment in mutual funds. Entry loads for mutual funds are abolished by SEBI. These loads are charged to deter investors from premature withdrawals. They do not have an impact on the return of the fund per se but will have an impact on the investor if he opts to withdraw investments within the specified period. Generally, funds keep exit load as 1% of the amount withdrawn exceeds a specified percentage of investment before a specified time (12 months in general).

• Tracking Error:

As discussed above, each index fund tracks an index and invests in the same proportion of index to give the same return to its investors. Tracking error is the difference between the return of the fund with that of the benchmark. Generally, tracking errors are calculated against the total returns for the specific benchmark which includes dividend payments. At the inception of the article, I have tabulated the difference of returns between benchmark & fund’s return.

This percentage will tell how well the company can track the benchmark index. This ensures that any entry/exit of stock into an index is tracked in advance to ensure that the same positions are taken in the underlying fund to ensure the same returns as that of the benchmark.

Reasons for such error are elaborated below:

1. Ideally, all the corpus of the fund should be invested in securities underlying benchmark. But the same is not possible since the fund will incur some expenses which need to be borne from the corpus. As discussed earlier, a higher expense ratio means a lower portion of the corpus is being invested & hence a lower return from assets.
2. One of the primary reasons for tracking error is mutual funds generally keeps a certain portion of assets in form of cash to fund withdrawals. Inflow may also happen due to corporate actions like dividends etc.
3. If underlying securities breaching the upper/lower circuit, then it may not be possible for the fund to enter/exit a security increasing tracking error.
4. Corporate actions such as the conversion of other securities into shares forming underlying index will increase market capitalization of the stock and will have an impact on the composition of the index.

Investing in funds having good tracking error is better. Lower tracking error is being termed as good tracking error.

• The minute difference in composition when compared to benchmark:

Even though all funds tracking the same index tries to invest funds in the same proportion as that of the underlying index, a minute difference is always bound to exist due to various reasons such as holding cash for meeting contingencies, change in the composition of the index, etc. Composition of 3 Sensex index funds & 3 Nifty 50 index funds in top 10 stocks of the underlying index are tabulated below for reference:

Green colour indicates the highest percentage of investment being made, yellow stands for next highest & red stands for lowest. The highest contribution does not mean that fund gives high return / low return. Return of a stock depends on the independent movement of the security.

• Fund Turnover:

Fund Turnover w.r.t. mutual fund means the number of transactions (either buy/sell) that a fund undertakes. A higher number of transactions means high fees & correspondingly low returns. Each investment/withdrawal does not mean that the fund manager will purchase/sell such shares in each company to ensure similar composition. Each fund house will have an agreed amount/percentage as Cash & the excess amount of assets alone will go into the investment of the fund.

• Tax Cost Ratio:

The Tax Cost Ratio refers to the amount that a fund’s annualized return is reduced by taxes that investors pay on distributions (including stock and bond dividends and capital gains distributions). Efficient planning of tax by investors will ensure that maximum return.

• Perception of the index:

Even though most of the index funds keep recognized indices as their benchmark, some of the index funds create funds that invest their funds according to indices created by it as the benchmark. Since returns of benchmarked index could not be tracked efficiently, tracking error can not be computed to ensure the efficiency of the fund.

Conclusion:

This article summarizes reasons for differences as mentioned above in general. Names of index funds mentioned above & details thereon should not be construed as investment recommendation and all information mentioned above is purely for educational purposes only.