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Index Funds-Even Passive Investing works wonders

, October 24, 2012, 0 Comments

Index funds invest in a basket of predefined stocks of an index like Sensex or Nifty. These funds follow a passive strategy, instead of picking individual stocks.

The fund manager simply follows the index and invests in all the constituent shares in the same ratio as in the index.

History shows that in the long run, a thoughtfully designed diversified strategy of passive funds typically beats all but a few active managers.” ~ Eugene Fama Jr.

Theoretically, these funds seek to reflect the return of the index. Hence, there is no possibility of loss owing to a wrong call taken by the fund manager.

On the contrary, they are never able to outperform the broader indices the way diversified equity funds do. It’s also easy for an investor to understand and follow them.

Why does Indexing out-maneuver the best minds at Stock Market? According to Burton Malkiel “it is because the best and brightest of the financial community have made the stock market very efficient.

When information arises about individual stocks or the market as a whole, it gets reflected in stock prices without delay making one stock as reasonably priced as another.

Active managers who frequently shift from security to security actually detract from performance, compared to an index fund, by incurring transaction costs.”

A major advantage of investing in an index fund is the low Expense Ratio because of lack of active management. Index funds employ a buy and sell strategy based on movement of the index and do not incur transaction costs and fund managers’ fees.

As a result, their annual fund management fee is between 1 to 1.50 per cent in India, as against the 2 to 2.25 per cent charged by diversified equity mutual funds. All this cost savings can be significant, especially if you are a long-term investor.

Replicating the broader indices also provides diversification and lower volatility in comparison to individual stocks, making it a safe option to invest.  Also in Index funds, the risk associated with a fund manager is nullified, whether it is the possibility of taking wrong investment calls or quitting the fund.

As these funds aim to match market returns, both under- and over-performance compared to the market is considered a “tracking error”, which is their biggest drawback.

A well-managed Index Fund should ideally have a tracking error of 5 percent or less, but it is much more in India at present. Some schemes have returned even more than 10 per cent lower returns than the underlying indices during the past years.

Index funds are ideal for investors who are willing to participate in equities but don’t prefer to take much risk. For a new investor who wants the upside of equities without taking much risk, index funds are the right option to begin with.

Index funds also make an ideal investment option for investors who prefer to take only market risk and not fund manager risk. But remember, these are also equity funds.

So, in case of sharp market downturns, these funds will also be affected and can dent portfolio returns. Index funds are a good option in bad market conditions, when the low fee levied by the fund house reduces the loss to you.

Ideally, a 20-25 per cent exposure to Index Funds is recommended because investing solely in them will deprive the investor of earning the higher returns generated by mid-cap and small-cap stocks.

Contrary to the popularity of Index Funds in the developed markets, they are yet to make a mark in Indian Mutual Fund Industry mainly because of two reasons:

  • Index funds are not really low-cost in India, and
  • Actively managed funds have performed better than index funds

Goldman Sachs (GS) Nifty BeES, the biggest Index Fund in india, manages less than 600 crores of AUM which is peanuts as compared to biggest funds from other categories.

On the performance front as well, Index funds in India have performed poorly as compared to actively managed funds.

Even the low cost advantage is missing in case of Index Funds in India. All over the world the index funds have ratios around 0.35% with Vanguard offering funds with 0.18% load.

Whereas in India, most index funds charge a 1% plus recurring expense which is too high for an index fund. Though there are few funds with a low expense ratio like GS Nifty BeES with approximately 0.50% expense ratio, as a category the low cost has still not become a norm in Indian context.

Though Index Funds in India have not been at par with global standards, they might align with them in near future as our stock market will develop in size and reach.

Also, when the out performance of diversified equity fund schemes will go down (as witnessed during last few years), we may see more investors opting for Index funds ultimately giving a boost to the category.

About author
Dr Naveen J Sirohi is a Ph.D. in Commerce from CCS University and a Certified Financial Planner. Currently he is Assistant Professor (Finance) in the Department of Management at BCIPS, New Delhi. He has more than 10 year of experience including HDFC Bank and Corporation Bank. His domain expertise include Personal Finance, Financial Management, Risk Analysis & Insurance Planning, Retirement Planning, Taxation, Security Analysis & Portfolio Management and Financial Statement Analysis. Dr. Naveen also runs a Consultancy firm, PRUDENT ADVICE, providing Financial Planning services assisting clients achieve financial freedom. ...more