In the recent past, there has been a growing shift from direct equity investing to investing in mutual funds. Investors have started realising that investing in equity directly is a full time job and therefore not every one’s cup of tea. Moreover, it requires thorough knowledge of dynamics of economy and analytical skills which average investors may lack. For the laidback, average index funds offer the best solution. This article aims to discuss everything you need to know about Index Funds.
Index Fund – The Basics
The oldest and most popular one is Sensex of Bombay Stock Exchange (BSE). Nifty of National Stock Exchange is new generation equity index. Both help measure and track mood and movement of the markets. There are around 39 indexes on BSE such as BSE Greenex, BSE Carbonex, BSE IPO. The primary purpose of different indexes is to reflect the movement and trend of prices of equity shares of various class or segments which they represent. There are indexes to represent large cap, small cap, consumer goods shares, bank shares. As an investor cannot buy an index directly so to replicate the specific index for helping investors invest money, mutual fund houses have created various index funds.
An Index fund can be defined as a scheme which has as its components all the constituents of the index which it is tracking, referred to as parent index. The purpose of the index fund is to generate returns in line with those generated by the parent index. These funds hold various stocks in the same proportion as in a parent index, which means the scheme will perform in tandem with the index with some minor difference known as tracking error. The index funds are not supposed to outperform but mimic the performance of the parent index.
Special features of Index Funds
Most of the equity schemes are actively managed by the fund manager in an endeavour to generate better returns and beat its benchmark. Such active management of the fund may or may not generate better returns than the benchmark. As compared to actively managed scheme, Index Funds are passive funds where the fund manager just needs to imitate the composition and weight of the parent index so these funds do not have expert fund manager and team of research analysts. The job of buying and selling for these index funds can be automated to a large extent without major human intervention. Based on the result of automated system for tracking the index, only for buy and sell decision you need to hire employees. As the fund manger has to replicate the portfolio of the benchmark index, no major and frequent churning of the existing portfolio will be required. Lower level of churning ensures lower transaction costs for the index fund. The savings in overall costs help the index funds have lower expense ratio as compared to actively managed funds.
Due to higher fund management charges many of the actively managed funds are not even able to perform at par with the index they are mirroring. Due to lower fund management expenses sometimes index funds are able to score over the actively managed funds especially during less volatile market conditions.
As per the Efficient Market Hypothesis (EMH) theory, it is impossible to consistently beat the market without risks. The markets in developed countries are more efficient, transparent due to quick dissemination of information and strict regulatory compliances and monitoring. It may not be the same in India where dissemination of information is not prompt which results in some level of insider trading opportunities and selective information leak.
The equity Index funds are tax efficient because any profit made on equity index funds are fully exempt up to Rs 1 lakh beyond which these are taxed at 10% if held for more than 12 months. Redemption of such units within 12 months is taxed at flat rate of 15%.
The actively managed equity funds charge you an exit load of around 1% if redeemed within one year where as the lock in period for exit load purpose varies from 0 days to 30 days in case of Index funds, thus giving you the opportunity to play in the market without actually taking any direct exposure to specific security.
What is tracking error?
The mutual funds have to maintain some portion of their funds in cash in order to meet the redemption. Cash maintained in the index funds results into funds fully not deployed in the underlying securities of the parent index, the actual returns generated by the index fund may vary and deviate towards either side depending on the movement of the parent index during that period. The tracking error measures how much the returns generated by index fund have deviated from the benchmark it is tracking. Lower the tracking error, the better the performance of the fund. So the best index fund is which has zero tracking error. Even the positive tracking error for an index fund is a bad thing to have as that reflects the fund manager’s call on the market, which the fund manager is not supposed to take.
Should You Invest In Index Funds?
The Index funds are ideal funds for investors who do not wish to avail services of any investment advisor. They can invest in index funds as the index funds broadly mimic their parent index which is expected to go up in the long run.
Generally, when you invest through a distributor he just provides execution services and in most of the cases does not help you in reviewing the portfolio. Index funds are ideal for the investors who do not want to take risk associated with a fund manager. For average investors it is not possible to track the physical movement of the fund manager moving out from the scheme or the fund house. Many schemes experience deteriorating performance once the star fund manager leaves the fund house. In case of an Index fund you need not worry about the fund manager as manager does not have any major role in performance of an index fund.
What Type Of Index Funds Should One Invest?
Since there are many index funds tracking various benchmark indexes. One who is aiming for long term goals like retirement or child education/marriage should invest in an index fund covering the broader market. As there are various indexes restricted to specific segment, theme and industry like mid cap or small cap or sectors like banks, consumer durables, health care, information technology, it is advisable to diversify the investment through broad based index fund.
A broader index fund provides broad market exposure, low operating expenses and low portfolio turnover. While selecting an index fund in particular category, please select the index fund with lowers tracking error which reflects the efficiency of the operations of the fund. (The writer is a tax and investment expert and can be reached on email@example.com and @jainbalwant on his twitter handle)