An Eye on the Index

If you are new to equities and mutual funds, an index fund may just be what you are looking for. These funds have a lower risk-return profi...

If you are new to equities and mutual funds, an index fund may just be what you are looking for. These funds have a lower risk-return profile when compared to actively managed funds. This means that while returns can be less than that from actively managed funds so will returns. More simply these funds will rise less and fall less than other equity funds.

Index funds replicate the performance of a stock market index. This is achieved by investing in the same stocks as in the index. The proportion of stocks is also matched with that of the index. Thus in India most funds track either the BSE Sensex or the S&P CNX Nifty. There are other indices such as the BSE 100, BSE 200 and S&P CNX 500. However, there are no funds tracking these. So index funds are currently limited to those, which track large cap stocks. By virtue of their objective of tracking an index these funds follow a passive investment strategy. The portfolio turnover is limited to re-balancing arising out of new subscriptions, redemptions, dividend payout and change in the composition of the index. So should one expect the returns from these schemes to exactly match that of the index? This does not happen in reality and usually there is a small difference between the return of the index and the fund. Such deviations are known as tracking errors and arise out of a number of factors.

Thus any delay in purchase or sale of shares due to illiquidity in the market, delay in registration of securities or other causes may cause a tracking error. The Nifty/BSE Sensex reflect the price of securities at a point in time, which is the price at the close of the business day. The scheme may however, buy or sell these securities at different points during the trading session. Therefore prices at which the scheme trades may not be identical to the prices which are registered for the day. This can cause differences in the returns between the fund and the benchmarks. The index providers during their reviews of the indices may make a change in their composition. In such an event if the reallocation process does not take place instantaneously a precise mirroring between the index and the benchmark may not take place. By virtue of being an open-ended scheme the fund may hold appropriate levels of cash or cash equivalents to fund redemptions, which happen on an ongoing basis. Besides the expenses charged by the fund, the very process of investing requires the payment of brokerage which will eat into returns.

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One thing is clear that these funds are not designed to be a top-performer. To this end the index fund is more or less managed by a robot. For the fund manager will simply buy all the shares in a given index. However with actively managed equity funds, a fund manager can make costly mistakes, such as not being invested when the market goes up, being too aggressive when the market plummets, or just being in the wrong stocks. An actively managed fund can easily under-perform the overall market index that it’s competing against. An index fund, by definition, can’t. Index funds make great sense for investors who fear that fund managers may make mistakes and under-perform the market. Many investors, especially the believers of Efficient Market Theory, have reason to favour index funds on the assumption that trying to beat the market averages over the long run is futile, and their investments will at least keep up with the market.

One of the important features of index funds is that costs to investors are kept low. This arises, as there is no need to spend on research and other related areas. In view of the passive nature of this fund its expenses should be lower than that of actively managed funds. Investors should examine the expense ratios of their index funds. My picks are IDBI Principal Index Fund. This tracks the S&P CNX Nifty and has the lowest tracking error amongst peers. Franklin India Index Fund Sensex has the lowest tracking error, which track the Sensex.

(The author is the chief executive of ValueResearch, which tracks mutual funds. He can be reached at dhiren@valueresearchindia.com)