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Index Mutual Funds

Although I would prefer largecap diversified funds, index funds are a good option for those who are starting and do not know much about investing in equities. And, this is a good time to begin investing in this asset class.

Another reason to invest in index funds is absence of confidence in the market. With the Bombay Stock Exchange Sensitive Index, or Sensex, looking highly volatile with a downward, it is difficult to take a call on an equity-diversified fund.

The main advantage of investing through an index fund, especially in these times, is that these are passively managed. Since the scheme invests the money, according to the index, there is little risk of active management. Then, there are costs as well. Most index funds charge 1-1.5 per cent as annual fund management fees, whereas equity diversified funds can charge 2.25 per cent.

As far as returns are concerned, equity-diversified funds have returned 9.25 per cent in aone-year period, whereas index funds, such as BeES, have returned slightly over 22 per cent. Similarly, funds investing in the Sensex and the Nifty such as Franklin India Index NSE Nifty and HDFC Index Sensex have returned 11-12 per cent. And, if one takes into account the cost-saving due to lower fund management fees, the returns would be at least 100 basis points more.

Although actively-managed funds tend to outperform benchmark indices such as the Sensex or the Nifty, in bad times, a wrong call by fund manager can hurt badly.

An index fund mirrors the benchmark, as it invests in stocks comprising the index and in the same proportion. Their returns should ideally mirror the performance of the underlying index. For instance, the fund manager will passively invest in Nifty-50 stocks in proportion to their market capitalisation. Due to this, index funds are known as passively-managed funds.

However, many times, there is a difference in returns from the index and the scheme that mirrors it. It is because there is a tracking error, which occurs when the fund manager actively manages the scheme. For instance, the Nifty has returned 11.6 per cent in the last one year, whereas the Nifty Junior BeEs has returned 9.37 per cent, a tracking error of 3.28.

In the US, the tracking error that can either be positive or negative is less than a per cent. In India, this error is sometime five per cent or more. According to financial planners, you could invest up to 15-20 per cent of your portfolio into index funds. If you are an experienced investor who does not have index funds in your portfolio, fund managers advise opting for it only if you do not want to keep an active track of your portfolio.

 Buy index funds only if you want safety on the equity side and don't want to keep a constant watch on it. Over a longer term, equity-diversified funds will outperform index funds, especially in the case of emerging markets like India.

This is because fund managers of emerging markets can pick stocks which are multi-baggers. On the other hand, fund managers in developed and mature markets do not have many such opportunities.

Happy Investing!!

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