The concept of index funds is still at a nascent stage in India. For the uninitiated, index funds are equity funds that invest in the selected benchmark index. The fund manager simply mimics the index by investing in all the constituent stocks in the same proportion as in the index. In other words, as an investor in an index fund, you end up buying the index.
Index funds are good solutions for investors who want to invest in equities at a very low cost. As the fund portfolio mimics the index, there is no fund manager risk and investors need not lose money just because the fund manager got it wrong by a wide margin. Many times, investors do not understand which fund to invest in or don't have the time to find out one. In such a scenario, an index fund can be a better vehicle to invest in equities.
Checklist For Investment
However, before you commit your money to an index fund, there are two important factors you need to consider. First is the tracking error – the deviation in the returns of an index fund from the returns offered by the underlying index. It measures how closely a fund follows the underlying index. Always invest in an index fund with the minimum tracking error.
The second factor is the expense ratio – the lower the ratio the better. So it pays to invest in a fund that offers you returns similar to that of the index and at the cheapest cost. For example, the Nifty Benchmark ETS offers to invest in S&P CNX Nifty index and comes with an expense ratio of 0.5% and tracking error of 0.09%.
The ease of purchasing and selling is another important aspect. Many investors prefer to invest in exchange traded index funds than their traditional counterparts. The only additional risk investors face when they invest in an exchange traded fund is that they may not get to exit at the fund's NAV in volatile markets. To overcome this problem, it makes sense to invest in a large-sized ETF that is fairly traded on the stock exchange. If you are a small investor and not really clear about which ETF to choose, it is better to invest in a traditional index fund using the paper route, which will ensure that you get entry and exit at the NAV, albeit for an extra cost.
What is the down side?
But index funds are not without flaws. Since the fund manager does not take a call on the equity markets, you cannot expect him to book profits. During extreme bull runs, the fund manager remains invested fully in the index and investors do not get the opportunity to book profits. A fund manager of a diversified equity fund may increase the cash level in his portfolio at higher levels and protect downside. But there is a way out. "If you stick to your asset allocation and keep rebalancing your portfolio at regular intervals, you will get to book profits.
Let us understand this with an example. Assume that you have invested . 1,00,000 in the ratio of 60:30:10 in equity, fixed income and gold. After a year, your equity investment doubles, the fixed income portfolio grows to . 33,000 and gold goes up to . 17,000. Your portfolio value soars to . 1,70,000. In that case, it makes sense to sell equities worth . 68,000 and transfer that money to the fixed income portfolio. That helps you to take money off the table in a systematic manner.
Options For A Portfolio
Over a period of time, with the entry of new players in the mutual fund business, Indian investors now have multiple options in the index investing space. If you have a view on a specific sector, you may choose to invest in a sectoral index fund. For example, after the recent fall in the banking stocks, long-term investors are finding the space attractive. Such investors can look at funds like Banking BeES and Kotak PSU Banking ETF. If you are bullish on the infrastructure space, you can invest in Infrastructure BeES. For investors looking for Shariah-compliant equity investing, there is Shariah BeES.
Investors also have options like fundamentally weighted index fund. Motilal Oswal Asset Management Company has launched a fundamentally weighted index fund that invests in Nifty stocks based on the weights arrived at by using company valuations and financial parameters.
In a market capitalisation weighted index, investors end up buying a higher percentage of relatively expensive companies and a lower percentage of relatively cheap companies. In comparison, in a fundamentally weighted index, investors end up buying more of fundamentally sound and relatively cheaper companies.
Then there are also index funds that allow investors invest overseas. The Hangseng BeES and Motilal Oswal Most Shares Nasdaq 100 two such funds.
Investors can introduce meaningful diversification in their portfolio by investing in Nasdaq 100, which is expected to offer healthy earnings growth and has low correlation with Nifty. Though there are limited options available to invest overseas, it becomes imperative that investors consider such options to qualitatively improve their portfolios.
Within the asset allocation limits, an investor can consider phased exposure to such products.
Investors can use index funds to effectively build a strong equity portfolio. If you do not intend to take efforts of ascertaining the best fund to invest in or don't have the time to do research to pick a fund, it is better to construct the equity portfolio using index funds.
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