The expense ratio of these funds are supposed to be very small as they rely on a computer model with little or no human input in the decision as to which securities to purchase. It is this passive management of these funds which makes them a low-cost affair.
However, the investment purpose of the investor gets defeated if the expense ratio of these funds happens to be close to that of the actively-managed funds such as diversified equity funds.
According to analysts, the ideal expense ratio for the index funds should be in the region of 0.75-1 per cent.
But, after taking into account the expense ratios of 22 index funds, it was found that five funds had expense ratios of more than 1.5 per cent, which included three funds with expense ratios of more than 2 per cent.
The average was 1.3 per cent. While expense ratios of four funds were between 1 and 1.5 per cent, only nine funds had expense ratios of 1 per cent or less than that.
The lowest among the 22 was Principle Index Fund with an expense ratio of 0.75 per cent, and the highest was ING Nifty Plus Fund-Growth with expense ratio of 2.5 per cent.
Recently, the Securities and Exchange Board of India had issued a notification to the effect that expenses charged on index funds would be capped at 1.5 per cent.
An index fund replicates the index (it has chosen). It does not seek to outperform it. Since there is no attempt to do better than the index, the management here is "passive", not "active".
For example, an index fund that tracks the Sensex will exactly invest in its 30 constituents in the same weightage as in that index. Again expense ratio does not necessarily mean a lower tracking error.
The funds with highest expense ratios, LIC [Get Quote] MF Index Fund-Sensex Plan (G) and ING Nifty Plus Fund-Growth have delivered returns of 23 per cent and 21 per cent respectively in the last one year, while the Sensex return has been 26 per cent during the same period.
However, for most of the funds, the tracking errors were larger than what most intelligent investors would be comfortable with. (The average return being 21 per cent compared to 25 per cent of the underlying indices).
Between April 30, 2007 and April 30, 2008, the average returns from different indices such as Sensex, Nifty and BSE MidCap were 26 per cent, 26.3 per cent and 24.9 per cent respectively. Tracking error occurs when a fund manager fails to replicate the index he has chosen.
When contacted, a senior official of ING Investment Management (India) said the expenses were higher because of lower corpus.
"The corpus of the fund is around Rs 10.21 crore, hence the expenses are more. For the expense ratio to be less than 1.5 per cent, the corpus needs to cross Rs 100 crore (Rs 1 billion)," he explained.
Commenting on the same issue, Vineet Vohra, CEO and MD of the company, said ING Investment Management was not exactly an index fund, it was a bit different.
"It's an enhanced index fund with diversification. We seek to outperform the index in the long run, hence the expense ratio is higher than the regular index fund," he said.
Speaking on the issue, Sandesh Kirkire, CEO, Kotak Mahindra Asset Management Co Ltd, said the ideal expense ratio for these funds should hover around 1 per cent, with a minimum tracking error.
"Indexing is fast catching up in India, and with 20 per cent of the funds outperforming the index, it makes it a good investment venture," he added.
The company is set to launch an ETF, Kotak Sensex, in the coming week.
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