Should you invest in Motilal Oswal Index Fund NFOs

Motilal Oswal AMC has just come out with four broad market index fund NFOs. What sets these NFOs apart is that three of them are a first of their kind in India. So far we have not had any broad market index funds outside of the largecap indices. The four funds based on Nifty Indices are as follows:

• Motilal Oswal Nifty 500 fund
• Motilal Oswal Nifty Bank Index fund
• Motilal Oswal Nifty Midcap 150 Index fund
• Motilal Oswal Nifty Smallcap 250 Index fund

Barring the Nifty Bank Index, none of the other indices has any funds based on them right now. 

How are these funds different

These are the first Midcap, Smallcap, and full market index funds in India (since Nifty 500 represents 96% of the total free-float market cap of NSE, it can be reasonably considered as the full market). Thus far we haven’t seen any index funds based on mid and smallcap indices. These funds will own the entire midcap space, as defined by SEBI, and the top 250 companies in the smallcap space respectively. 

The defining factor is that these funds will be pure midcap and pure smallcap funds. As per SEBI categorisation, a midcap/smallcap fund needs to hold only 65% of its portfolio in midcap/smallcap stocks. As a result, most actively managed funds have some exposure to other market cap categories. So a midcap fund can have 10% smallcap and 20% largecap exposure. Or a smallcap fund may have 30% midcap exposure. However, by investing in indices, these funds will not have any exposure outside their defined market cap category.

How have these indices performed in the past

As these funds are based on stock market indices. So we can judge the past performance can by looking at the index performance itself. Here’s how these indices have done in the past 10 years:

As you can see, despite the recent underperformance of mid and smallcap stocks, as compared to large caps, both the Nifty Midcap 150 TRI and the Nifty 500 TRI seem to be outperforming Nifty 50 TRI in the long term. Of course, this outperformance also comes at a heightened risk. While the volatility of the Nifty 500 index is largely similar to that of the Nifty 50, both midcap and smallcap indices outpace the largecap index in volatility. This higher risk is the reason why you are seeing the smallcap index underperforming right now. 

However, owning an index inherently lowers your risk as compared to actively managed funds for two reasons:

1. There is no fund manager bias
2. Your portfolio is more diversified than an actively managed fund

Because of the higher number of constituent stocks, the weight of individual components is likely to be lower. For instance, the largest component of the Nifty Midcap 150 index is Federal Bank, which has a weight of 2.25%. Hence, the risk of underperformance due to the poor performance of any single company is lower.

Should you invest in these funds

Index funds track the performance of the markets. Hence investing in these funds assures you that you will not underperform the market by a significant margin at any point. However, it also means that you will not outperform the market either. 

It also needs to be kept in mind that index funds will not give the exact same returns as the index itself. Differences arise somewhat due to tracking error and largely due to the expense ratio. Motilal Oswal AMC has said that the expense ratio of these funds will be under 0.50%, which is lower than actively managed funds. 

We are also a bit sceptical about their ability to replicate the smallcap index and BSE 500 index in full. Some smallcap stocks suffer from liquidity issues. This means that the fund manager may not always be able to buy and sell as per their wish. Liquidity issues also mean that the impact cost is high. Impact cost is the price movement caused by the placing of an order. So if a fund manager places a large order on a smallcap stock, the price may move significantly due to this order itself. However, the AMC assures us that NSE has imposed strict qualifying criterion for including stocks in these indices. This means that such issues should not crop up under normal circumstances.

Regarding actively managed funds, in India, fund managers have continued to show the ability to outperform in the multi, mid and smallcap space. We are yet to reach a stage where sustained outperformance is a thing of the past. While the recent glut in the market has caused a lot of funds to underperform, past experience tells us that this has been the case in earlier bear markets as well. Suffice to say, the days of actively managed funds are not over yet.

So while you may want to invest in these funds, we would not recommend holding your entire portfolio in index funds yet. These funds can form a part of your portfolio for their ability to replicate the market returns at a lower risk.

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