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Are index funds right for you?

July 01, 2009 14:18 IST

Have you heard about index funds? No? Well, that is not surprising since these funds are not aggressively marketed by mutual fund agents. But they do exist in India.

Here is a lowdown on these oft ignored funds.

What are index funds?

Mutual funds follow two types of investing methods. One is active investing where the fund devotes time and effort in order to detect and buy quality stocks. Most of the funds fall in this category.

The other is passive investing. It is far simpler and consists of just tracking the benchmark index. This strategy is followed by index funds. These funds constitute their portfolio using the same stocks and in the same ratio as found in the index.

These funds simply mirror the index. So their returns are in the same line as the returns generated by the index. They will never outperform the index.

What are the pros and cons of these funds?

These funds do have their own pros and cons. Here are the pros and cons of these funds.

Pros:

  • Lower costs: As these funds employ buy and sell strategy actively, they do not incur heavy trading costs and analysts' fees.
  • Knowledge of portfolio: Since these funds track their benchmark index, they hold the same stocks in the same ratio as are present in the index. This means you will know where the fund has invested your money. You are not in for any nasty surprises.
  • Returns in line with the index returns: The aim of index funds is to mirror the index and generate returns that closely match the index returns. They do not try to beat the index. This is better than the actively managed mutual funds, where any wrong decision made by the fund manager can cause significant variation from the benchmark index.
  • Easy to understand: These funds are easy to understand as these funds simply reflect the performance of underlying index. So even novice investors can understand what these funds are all about.
  • Cheap exposure to index: Can you imagine investing in all the 30 Sensex stocks or 50 Nifty stocks for a nominal amount of Rs 5,000? This is possible only with the index funds.

Cons:

  • Tracking error: While technically index funds are expected to mirror the performance of its underlying index, most funds tend not to follow this rule strictly. Some funds have altered their exposure to the index stocks and have changed the ratio. This has led to the tracking error, giving rise to the discrepancy in the index returns and fund returns. As a result, most funds have outperformed or underperformed their indices by a big difference.
  • Affected by market fluctuations: Remember that just like actively managed mutual funds, these funds are also equity funds. So in case of sharp market downturns, these funds also tend to be affected.
  • Affected by alteration in index composition: The market index is nothing but a group of stocks that represent a particular segment of companies. When there is a change in the composition of the index, i.e. a new company is included or a company is removed or the representation of the company in the index changes, the index funds must incorporate these changes. They will have to provide for these changes by buying or selling the corresponding stock(s).
  • Reduced investment scope: Unlike US indices like S&P 500, which contains 500 largest companies in terms of market capitalisation, Indian indices have narrower exposure to companies. E.g. Nifty consists of 50 companies and Sensex of just 30 companies. This excludes a large range of companies to which you don't get exposure, but can give you very good returns in the long run.

Is it right for me?

These funds are suitable for novice investors who don't have a clue about stock market investments. However, over the long term, these funds should form a part of overall portfolio of investors. This is because investing solely in these funds will deprive the investors of earning higher returns generated by mid and small cap companies.

What are the returns generated by these funds?

Despite their lower cost, most index funds have managed to generate returns below those generated by actively managed funds. In fact, some of them have managed to generate returns below those generated by their corresponding benchmark index.

Are these funds suitable for India?

Unlike the United States, Indian market is still to mature. There are many hidden investment gems here. These companies have the potential to generate astounding returns, despite their exclusion from the index. Index funds are unable to capitalise on these opportunities.

Moreover unlike the US, the fund management charges for Indian index funds are still high. Though they are not as high as the charges for actively managed funds, it doesn't make sense to pay high charges for passively managed funds. While they are not advisable as of now, they may be considered in future once the Indian markets mature.

If you are looking to invest in the funds with low charges but with less risk, then you can consider index funds. However ensure you do not rely solely on these funds, as it will deprive you of various investment opportunities that are available in the market, since these funds invest only in selected stocks.

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