In this article I would like to discuss one mutual fund (MF) product, which you can start investing when the equity markets are down. So, let me explain what index funds are and who should invest.
What are index funds?
There are different indexes of various segments of the equity market to reflect the movement and trend of prices of equity shares of a various class or segment which they represent. There are many indexes to represent various categories and sectors like large-cap, small-cap stocks, consumer goods shares, bank shares, etc.
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 hereinafter. As an investor can’t buy an index directly so to replicate the specific index for helping investors invest money, mutual fund houses have created various index funds.
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, as close as it is possible.
Most of the equity schemes are actively managed by the fund manager to generate better returns than its benchmark, but Index Funds are passive funds where the fund manager just replicates the composition of the parent index. Since the fund manger just has to replicate the portfolio of the benchmark index it does neither requires expert fund manager no it requires frequent churning. Both these factors lower the overall costs for the index fund. Due to lower fund management expenses sometimes index funds are able to score over the actively managed funds especially during less volatile market conditions.
The markets in developed countries are more efficient, transparent due to quick dissemination of information and strict regulatory compliances and monitoring. It is not so in developing country like India. This leaves scope for some level of insider trading opportunities and selective information leak. In due course actively managed funds no longer will be able to beat the broader market index funds.
What is tracking error and index funds have tracking error
All funds have to maintain some case to meet the redemption. Due to cash maintained funds are not deployed fully. This results into deviation between actual returns of the index fund on either side depending on movement of parent index. This deviation is called tracking error Lower the tracking error is portrays efficiency of the performance of the index fund. So, the best index fund is which has zero tracking error. Positive tracking error is also reflects the fund manager’s call on the market, which the fund manager is not supposed to do.
Who should invest in Index Funds
These funds are ideal for people who wish to invest for long term to reap the potentials of equity to generate better returns and those who are not able to spare time to review their portfolio and neither do wish to avail of the services of investment advisors. 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. The index funds are also ideal for investor who does not want to take risk associated with a fund manager as for an average investors it is not possible to track the movement of the fund manager from the scheme or the fund house. Many schemes experience deteriorating performance once the star fund manager leaves the fund house/ scheme. In case of an Index fund, you need not worry about the fund manager as manager doesn’t have any major role in performance of an index fund.
What type of index funds one should invest?
Since there are many index funds tracking various benchmark indexes a lay person faces the problem of plenty. So, a lay person who wants to invest for long-term goals like retirement or child education/marriage should invest in an index fund which covers the broader market. There are various indexes tracking specific segment, theme, industry, etc., like large cap, mid-cap or small-cap, banks, consumer durables, health care, information technology, etc., it is advisable to diversify the investment through broad based index fund ideally large-cap fund.
A broader index fund provides broad market exposure, low operating expenses and low portfolio turnover. Moreover, 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. An ideal fund would be Nifty Index Fund or Nifty ETF Fund or a Nifty Next Index fund with least tracking error history.
The writer is a tax and investment expert and can be reached at email@example.com and on his twitter handle @jainbalwant