The hidden costs of index ULIPs: Why passive funds still charge active fees

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An index fund typically tracks a broad index, like the Nifty50 or NiftyNext50, without the need for an active fund manager to pick stocks. However, some index funds are designed with specific rules—known as “factors”—such as value, momentum, or growth, to create a more concentrated form of index investing. These are referred to as rule-based or factor funds.

Life insurance companies offer ULIPs, which combine market-linked returns with life insurance coverage. Much like mutual fund houses, life insurers offer a range of funds for policyholders to choose from, including some newer rule-based index ULIPs. These include offerings like the Nifty Alpha 30, Nifty 500 Momentum 50, and Nifty SmallCap 250 Quality 50 Index, among others.

Rule-based index ULIPs

The stock market contains a variety of indices, and life insurance companies can create new fund offerings by selecting certain stocks from a broader index, using algorithms to do so. These are known as rule-based or factor funds. Think of them as customized index funds, where a set algorithm—not a fund manager—selects stocks.

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For example, Bajaj Life Insurance’s Nifty200 Momentum 30 Index Fund uses a “momentum” factor, meaning it selects the top 30 stocks from the Nifty200 with the highest momentum (i.e., the best-performing stocks over the recent past). Similarly, Axis Max Life’s Nifty Smallcap Quality Index Fund invests in 50 small-cap stocks from the Nifty Smallcap 250 index, selected based on factors like earnings growth and low debt.

Since these funds simply track an index, their returns should align closely with the underlying index. However, data from various life insurers’ factsheets shows that tracking errors can be as high as 600 basis points, significantly diverging from the returns of the benchmark. In contrast, mutual fund companies typically strive to keep tracking error low, ensuring their returns mirror the index as closely as possible.

For instance, the Axis Max Life Nifty Alpha50 Fund, launched on May 31, 2024, has a tracking error of 453 basis points. Bajaj Allianz’s Midcap Index Fund and Nifty Smallcap Quality Index Fund have tracking errors of 600 and 500 basis points, respectively. ICICI Prudential Life’s Multicap 50 25 25 Index Fund reports a tracking error of 500 basis points, while its other funds fall between 200 and 300 basis points.

While queries to HDFC Life, Bajaj Allianz Life, ICICI Prudential Life, and Axis Max Life went unanswered, experts attribute the tracking error to several factors.

“The tracking error tends to be higher in funds with small-cap stocks, due to difficulties in buying or selling them in bulk because of low liquidity,” explained Deepesh Raghaw, an investment advisor registered with the Securities and Exchange Board of India. “Further, if a fund with lower assets under management (AUM) faces outflows due to fund switch or any other reason, it becomes difficult to follow the index to tee.”

Why tracking errors happen

One reason mutual fund companies maintain lower tracking errors is their ability to keep expense ratios low—typically under 1%, and sometimes even below 0.5%. This is because these funds do not require active management by a fund manager.

Surprisingly, life insurers do not pass on these cost savings to policyholders. While the Insurance Regulatory and Development Authority of India (Irdai) caps fund management charges (FMC) in ULIPs at 1.35%, most traditional ULIPs adhere to this same cap. Despite index ULIPs being passive funds that don’t need active management, life insurers often charge the same FMC as they would for actively managed funds. Even if the FMC is not capped at 1.35%, it could still be at least 1%. For example, Nifty Smallcap Quality Index Fund by Axis Max Life has an FMC of 1%.

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There are other charges in ULIPs such as premium allocation, policy administration and mortality charges. “Insurers recover it by liquidating units. This reduces returns compared to the benchmark at a policyholder level,” said Raghaw.

Additionally, Irdai has set a cap of 15% on investment assets for exposure to a specific industry, with a 25% limit for the BFSI sector and no exposure limit for the infrastructure sector. This restriction can hinder effective index replication.

This semi-active fund management, combined with small fund sizes at the start, doesn’t leave insurers much room to reduce FMCs, and that’s why they are often charged at 1.35%, similar to active funds, said Mithil Sejpal, founder of ValuEnable.

ULIPs also limit flexibility for investors. “While fund switches are allowed in ULIPs, one will have to stick to one insurer’s fund basket. In mutual funds, if you don’t like one AMC’s funds, you can switch to another AMC’s funds too,” said Raghaw.

Mint take

Index funds in ULIPs may follow a passive strategy, but they still carry the costs of active fund management. Although the back-tested data may show that these funds should replicate the returns of their benchmarks, the reality often falls short. Structural issues within ULIPs, such as high fees and product charges, further limit performance.

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If market-linked returns are what you’re after, mutual funds may be a better option. For those seeking life insurance, a term policy will provide higher coverage at a lower premium. ULIPs should only be considered for those who require a life cover along with savings-linked investment options.