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Ask Mint | Index funds are effective tools to gauge performance of indices

Ask Mint | Index funds are effective tools to gauge performance of indices
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First Published: Mon, Oct 05 2009. 12 22 AM IST

Updated: Mon, Oct 05 2009. 12 22 AM IST
We have no dearth of fund managers trying to beat the market. But most of them end way behind the benchmark.
In a market susceptible to random moves, active fund management looks as if you were trying to win a blindfold race by running faster. It’s no surprise that even the best fund mangers stumble many a time. If that be so, how can we ever hope to see investors and the market walking arm in arm? In a way, the answer has already been known to us in the form of index funds which follow a simple investment strategy—if you can’t beat them, join them.
Johnny: Everyone likes to win, no one likes to lose. But for winning in the market race we should know what an index fund is, right?
Jinny: An index fund is a portfolio constituted of stocks belonging to some market index such as the Sensex or Nifty. You can invest in an index fund either through a mutual fund or an exchange-traded fund (ETF). We have talked about stock market indices, mutual funds, and ETFs in detail earlier, and I hope you already have some idea.
The Sensex, as you may be aware, consists of 30 stocks in proportion to their free-float market capitalization. Likewise, the Nifty consists of 50 stocks in proportion to their free-float market capitalization. These stock market indices help us in gauging the overall mood of the market because they capture the price movements of the majority of stocks by market capitalization belonging to different sectors.
Illustration: Jayachandran / Mint
An index fund tries to track a particular index by including all stocks belonging to that index in its portfolio in exactly the same proportion as used by that index. Say, for instance, if one particular stock has a weightage of 10.86% on the Nifty, then an index fund tracking the Nifty would use 10.86% of its funds to buy that particular stock. If another stock has a weightage of 8%, then the index fund would allocate 8% of its funds for buying that stock. The end result is that you have a diversified portfolio, consisting of some of the best known firms, and your portfolio mimics the rise or fall of the chosen index.
Johnny: No nasty surprises. We live together and die together. Can you explain what other advantages an index fund has?
Jinny: The main advantage of an index fund lies in its cost. Since index funds require only passive fund management they are much cheaper than more actively managed funds in which portfolio managers make an effort to choose the right stock.
The expense ratio, which represents the value of total expenses as a percentage of the value of total assets under management, of most of the index funds in India lies between 0.50% and 1.5%, whereas the expense ratios of more actively managed funds could go up to 2.5%. Further, there is no guarantee that an active fund management would give a better result to investors.
Majority of actively managed funds fail to generate a return higher than a broader market index. Markets are after all known to be more efficient in doing their job than fund managers. In efficient markets, it is believed that you can beat an index only by assuming higher risk. A passively managed fund, on the other hand, gets a free ride by just letting the market do its job.
Johnny: Getting a free ride may sound tempting, but you should also tell me about some of the major pitfalls of an index fund.
Jinny: The biggest drawback of some of the index funds comes out in the form of tracking errors.
Theoretically, the return produced by an index fund should closely mimic the rise or fall of the concerned index. But in reality, due to what we call tracking errors, the fund may sometimes generate a return higher or lower than the actual movement in the index. Tracking errors could happen due to a variety of reasons.
First, some discrepancies might creep in at the time of allocation of funds itself, leading to greater or lower allocation of funds in different stocks.
Second, any change in the composition or weightage of the index requires rebalancing of the portfolio by the fund manager, which increases further the scope for discrepancies.
Third, it is often difficult for fund managers to trade at the market closing price, which means that the final value of the index and the value of the index fund portfolio on that day might show some difference.
Fourth, the fund managers may have to keep some cash ready to take care of redemptions by investors. Spare cash reduces the overall return of the fund.
Finally, overall expenses incurred by the fund eat into the return generated by the fund. The more the expenses, the more it would eat into the return, which would in turn create greater tracking errors. Due to these reasons, different index funds may show different performance. You should always take a closer look before choosing one.
Johnny: That’s true Jinny. One should always be careful. The more things look the same, the more they differ.
What: An index fund tries to track a particular index so that its returns mimic the rise or fall of that specific index.
How: An index fund includes all the stocks of a particular index in its portfolio in exactly the same proportion as used by the index.
Why: Index funds are popular due to lower expenses and better performance.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Mon, Oct 05 2009. 12 22 AM IST