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BASL Registration Number: 1951 | Non-Individual RIA. Regn No. INA000017620 | Validity Perpetual

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Should you consider NFOs of index funds based on just cheap cost?

Updated: Mar 18

Index funds are fast gaining popularity in India. These funds track a stock market index like the NSE Nifty 50, BSE Sensex, etc. For e.g., a nifty 50 index fund will have all the stocks of Nifty 50 and in the same proportion. Thus, if the market moves up by 10 per cent, the index fund value also goes up in the same proportion and vice versa. The investors hence do not have to worry about the performance of the fund manager and whether the fund will underperform or outperform the market. Since the fund manager doesn’t take any active calls to buy or sell the securities in the index, index funds are also known as passively managed funds.

In recent years, many big fund houses have launched index funds. To be precise, of the total 47 index funds which are present in India today, 51 per cent have been launched in just the last 2 years.

The returns generated by these passive funds are approximately similar to those offered by the underlying index. So, for e.g., how would you choose between 2 index funds tracking the Nifty 50 and offering similar returns as the index? It is obviously the cost factor that you will look at, i.e., is the total expense ratio. Although costs do impact the corpus value over long periods, choosing the cheapest index fund is not the answer here, atleast when it comes to the newer entrants.

Take the example of Navi Nifty 50 Index fund recently launched in July 2021 by Flipkart co-founder Sachin Bansal. This index fund is the cheapest in the index schemes category beating all others with an expense ratio of just 0.06 per cent under the direct plan. It managed to garner over Rs.100 crore in the NFO (new fund offer).

Should you invest in this new fund just because it is cheap? There are also other factors like tracking error and AUM of the fund house which matter. Tracking error is the difference in actual performance between the index fund and the corresponding benchmark. The fund house is a new entrant in the mutual fund business with no history or track record of performance. And, its tracking error is unknown. So, it is prudent to invest in index fund of an already established fund house who has a good track record and managing a higher AUM. A high AUM would help the fund manager manage sudden inflows and outflows in the fund.

Further, it has been observed that fund houses have increased the expense ratio of index funds once they garnered a decent AUM. For instance, UTI Nifty 50, the oldest and the top fund in the index category by AUM managing over Rs.4,000 crores increased the expense ratio from 1 per cent to 1.18 per cent p.a. this year. Similarly, HDFC, the second in size by AUM doubled its expense ratio from 0.1 to 0.2 per cent. So, it is wise to wait and watch as far as the relatively newer index funds are concerned.

You may think the hike in expense ratio is too small and the rate of return is not impacted much. Let me tell you that the impact on the absolute corpus is huge over the long period. To illustrate, suppose you start a SIP of Rs.50,000 in an index fund for 20 years with an expected average return of 12 per cent p.a. The fund house charging 0.1 per cent to you then doubles it to 0.2 per cent p.a. The increase in expense ratio would dent your corpus by approx. Rs.7 lakhs. The difference in corpus appears minimal at just 1.4 per cent but in absolute terms, it translates into lakhs of rupees.

The hike in expense is something which investors have no control over though. The increase in expense ratio is within the limit prescribed by the regulator. So, there is no guarantee that the relatively newer entrants will not hike their expense ratio once they garner a decent AUM. It is thus prudent to not fall for NFOs of index funds just because they are cheap.

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