Key Points

• Index funds invest in the stocks that form an index and in same proportion as that of the stocks in the index
• Index funds returns will always be lower than the returns of the index due to fund related expenses
• Index funds have a lower expense ratio as compared to other equity mutual funds
• Index funds are suitable for investors whose chief concerns is of cost
• There are actively managed funds whose costs are slightly higher but have delivered much higher returns than the index funds

Selecting a scheme to invest from a universe of close to 300 open ended equity oriented funds, can be quite confusing, especially if you are new to investing. Mutual funds are recommended if you are new to investing or if you do not have the time to actively manage your stock investments or if you wish to diversify into several stocks with a small investment amount.

Since the equity markets can be a confusing place for a new investor, the best way to start investing is to invest into an index mutual fund.

Index funds invest in the stocks that form an index and in the same proportion as that of the stocks within the index. For example, a SENSEX Index fund will only invest into the 30 companies that constitute the index and the weightage of a company in the fund portfolio is same as that of the weight of the company in the index.

The best thing about an index fund is that since it invests in companies that make up the index and often in the same proportion, the returns tend to be similar to that of the index. The slightly lower return than the index is due to the expenses involved in managing the fund.

Every mutual fund has a benchmark index against which the fund’s performance is tracked regularly. Broadly, there are two ways to manage a fund - Active management and Passive management. In active management, the fund manager tries to outperform the benchmark by actively selecting securities whereas in passive management, the fund manager aims to get returns similar to that of the benchmark. Index funds follow passive management. In India, we have Index funds mainly tracking either the BSE SENSEX or NSE NIFTY indices.

The unit of performance measurement of an Index fund is known as tracking error. Tracking error is the difference in returns of the index fund and the index. The tracking error measures how closely the return of a fund’s portfolio follows the return of the benchmark index. If it follows the index closely, the tracking error of the fund will be lower. Hence, a lower tracking error is always preferred than a higher tracking error. In most cases, the tracking error will be less than 2%. In chart 1, the performance of three index funds which track the Sensex and the performance of the Sensex is given. We can see that all the four lines move in tandem with each other over a period of 10 months.

There are advantages of investing in an index fund  a)      Lower turnover An index fund follows passive fund management. In passive fund management, there is low portfolio churning, which restricts the expenses incurred by the fund. Expenses like brokerage, Securities Transaction Taxes (STT) are directly related to the portfolio turnover. So, a lower turnover leads to lesser expenses incurred by the fund. b)      Lower expense ratio The expenses related to research and active fund management are also reduced leading to a lower expense ratio. Index funds tend to have expense ratios in the range from 0.75% to 1.5%, whereas actively managed equity funds generally have expense ratios over 2%. To that fact, the market regulator SEBI has capped the expense ratio of an index fund to 1.5%

Chart 1: Performance of SENSEX index funds against SENSEX

Limitations

However, there are two major drawbacks of index funds; the first has its roots in the passive investing methodology. When the underlying stocks in the index become overvalued, the fund manager is not allowed lock in the profits and invest in companies that are currently undervalued, which can give much higher returns going forward or invest into companies that can limit the losses, if the market were to correct itself. There by leading to a situation where in the investor get lower returns than that of the index no matter what. Whereas funds that allow active investing methodology are able to consistently deliver much higher returns than the index.

The other major drawback of investing into an index fund is that, since an index fund invests only in the securities that form the benchmark index, issue arises when a security in the index is replaced by another security. For example, in September 2008, Dr. Reddy Laboratories was replaced by Reliance Power in the S&P CNX Nifty. So, all the index funds tracking the S&P CNX Nifty had to sell all the shares of Dr. Reddy Laboratories and buy shares of Reliance Power. Since all the funds tracking the Nifty sold Dr. Reddy labs, they were sold at a discount.  Similarly, when they bought Reliance Power, they had to buy at a higher price thereby incurring a small loss. The tracking error of index funds increases due to such changes over a period of time. However, this drawback does not occur very often.

Table 1: Performance of SENSEX index funds against Fundsupermart’s Diversified Equity Funds

Index Funds or Actively Managed Funds

Some investors believe that it is hard for actively managed funds to beat the benchmark so the best way to gain exposure is through investing with index funds whereby, they are assured of lower costs. For investors whose chief concern is on costs, we believe index funds is a suitable investment option. However, we believe that there are a handful of fund managers who are able to generate better returns for investors despite charging higher costs. Our recommended actively managed funds like HDFC TOP 200 FUND or HDFC EQUITY FUND or DSP BLACKROCK TOP 100 EQUITY have actually outperformed Index funds by a large margin. (See Table 1). For investors who would like better-than-index performance, they should certainly consider our recommended funds.

 
Recommended Funds

Recommended Funds

HDFC INDEX FUND SENSEX PLUS PLAN- GROWTH