Index Funds-Low Risk!
While all actively managed equity funds aim to beat the index, an index fund aims to generate returns that replicate that of the stock market by investing in the stocks that constitute the market index. This sort of equity investing may be suitable for those who are looking to venture into equities, but are afraid to take big bets. Index funds, in comparison to actively managed funds, have a lower risk-return profile. Simply put, an index fund will not turn in that high returns as a diversified equity fund would when bulls are on a rampage. At the same time, this category will not be as severely hurt as the diversified equity category when stock markets tank.
What are index funds?
These funds mirror the performance of a stock market index, by investing in the same stocks as the index, including the number of stocks.
The reason: to ensure that returns from an index fund toe the line of that of the index. In India, most funds track either the BSE Sensex or the S&P CNX Nifty. However, index funds currently available don’t track other indices such as the BSE 100, BSE 200 and S&P CNX 500.
An exception here is Benchmark Mutual Fund’s Nifty Junior BeES, which tracks the Nifty Junior. The Nifty Junior is an index of the next 50 largest stocks by market capitalisation after those in the Nifty.
Following their stated objective of tracking an index, index funds follow a passive investment strategy. The portfolio turnover is limited to re-balancing arising out of new subscriptions, redemption, dividend payout and changes in the composition of the index.
Should one expect returns from these schemes to exactly match that of the index?
This does not happen in reality and usually there is a small difference between the return of the index and the fund. Such deviations are known as tracking errors and arise out of a number of factors.
Tracking error is an important variable to judge performance of an index fund. Tracking error may arise due to delay in the purchase or of shares due to illiquidity in the market, delay in registration of securities. The S&P CNX Nifty/BSE Sensex reflect the price of securities at a particular point in time, which is the price at the close of a business day. The scheme may, however, or sell these securities at different points during the trading session. Therefore, prices at which the scheme trades may not be identical to prices, which are registered for the day. This can cause difference in returns for the fund and the benchmark. The index providers during their review of indices may make a change in their composition. In such an event if the re-allocation process does not take place instantaneously a precise mirroring between the index and the benchmark may not happen. By virtue of being an open-ended scheme, the fund may hold appropriate levels of cash or cash equivalents to fund redemption, which happen on an on-going basis. Besides the expenses charged by the fund, the very process of investing requires payment of brokerage, which will eat into returns.
One thing is clear that index funds aren’t designed to be chartbusters. To this end, an index fund is more or less managed by a robot — the fund manager will simply shares in a given index. And unlike an active equity fund manager, he will not be tempted to indulge in active trading.
However, in the case of actively managed equity funds, a fund manager can make costly mistakes, such as not being invested when the market goes up, being too aggressive when the market plummets, or just being in the wrong stocks. An actively managed fund can easily underperform the overall market index that it’s competing against. An index fund, by definition, can’t. Index funds make great sense for investors who fear that fund managers may make mistakes and underperform the market. Many investors, especially the believers of Efficient Market Theory, have reason to favour index funds on the assumption that trying to beat the market averages over the long run is futile, and their investments in these funds will atleast keep up with the market.
One of the benefits of index funds is that cost to investors are kept low. This is because there is no need to spend on research and other related areas. In view of the passive nature of an index fund its expenses should be lower than that of an actively managed fund. Investors should thus examine expense ratios of their index funds, which should be lower than that of its actively managed counterparts. Within index funds a combination of low expenses and low tracking error will help in identifying good index funds.
While, index funds are touted as being safer than actively managed equity funds, it is important to note that this distinction is on a relative basis. At the end of the day, these funds invest in equities and so the underlying risks will be those of the equity asset class. And among different asset classes, equities possess the highest level of risk.
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