Is it time to invest your money in index fund or should you go in for a diversified equity fund? Here are the pros and cons
IF YOU have put your money in the S&P CNX Nifty Index 5 years ago, there is a 70% chance that you would have made more money than by investing in a large-cap fund. According to S&P CRISIL SPIVA report for the year ended December 2009, over 70% of large-cap funds underperformed the S&P CNX Nifty Index over a 5-year period. But at the same time, with the Sensex reaching near-18,000 level, market experts are calling it a stock picker's market rather than one for the index investor. So, what should you, as an equity investor, do? To know the way forward, you need to answer some of the following three questions.
Where do you come from?
The answer to this question can make your life simple. Investors prefer to choose between active or passive styles of investing depending on their needs. It has been observed in developed markets that institutional investors such as pension funds looking for asset exposure prefer to stick to passive investing by opting for index investments. These investors are willing to commit their money for a long term. Liquidity remains a key parameter in any investment decision of these investors, which is ably addressed by index investing.
The second segment of investors that would like to opt for index investing is known as 'asset allocators'. Once done with their risk profiling and investment needs, they prefer to allocate their money to various asset classes and hold on to them for a long period resorting to asset rebalancing at regular intervals. Index funds are preferred vehicles for many asset allocators. The rest of the investors, typically looking for alpha — the excess returns over the returns offered by the broad market — can look at actively-managed funds.
What ideology do you subscribe to?
While investing in the market, there is a need to have a sound foundation of a theory you subscribe to. Efficient market hypothesis (EMH) is a celebrated and equally-criticised theory in markets. EMH maintains that the financial markets are information-efficient. The prices of traded assets already reflect all the available information, and keep changing to accommodate any new information.
In other words, stocks always trade at a fair value and factor in all possible information available in the market. Hence, no investor can buy an undervalued stock or sell an overvalued stock. There is no scope for an investor to beat the market in the long run by earning excessive returns than the returns offered by the broad market.
Take Your Pick
What's Your Style?
Active investment refers to a portfolio management strategy where the manager or investor makes specific investments with a view to outperforming a given benchmark market index. A good example can be a diversified equity fund, where the fund manager tries to beat the benchmark, say BSE Sensex, in the long term. Active investment indicates high churn, higher costs and achievement of alpha - the excess returns over market.
Passive investment Passive investment strategy involves buying a basket of shares with a long-term hold. The basket of stocks bought typically is an actively-traded benchmark representing broad market or a sector. A good example can be investing in an index fund in which the fund manager buys shares of companies in the same proportion as they enjoy in the underlying index. Passive investment indicates low activity, low costs and nearly the same returns generated by the index or the underlying basket.
Factors To Look At While Choosing An Index Fund
Tracking error How much the index fund's returns have deviated from the underlying index, is termed as tracking error. Zero or lowest tracking error is a good indicator of a good index fund.
Expenses: Costs are low given the little activity required to mimic the index by the investment manager. Lower the costs, the better it is for index investors.
