Investing in equity directly is a fulltime job and requires adequate knowledge and analytical skills. Thus, for a lay investor investing in the index fund is a good option. Let us understand the nitty-gritty of the index funds.
What’s index fund
The Sensex and the Nifty are two major equity indexes of the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) for measuring and tracking the mood and movement of the market. There are many as many as 38 indexes on BSE.
The primary purpose of any index is to reflect the price movement of shares comprised in a particulars category or segment like largecap, smallcap, consumer goods shares and bank shares. Since we cannot buy any of these index, mutual fund houses have created index funds to replicate and imitate a specific index.
An index fund is a scheme of mutual fund, which invests in all shares included in the parent index. This scheme attempts to generate returns in line with those generated by the parent index. The index funds are not supposed to outperform the market, but mimic the performance of the parent index as close as possible.
Most mutual fund schemes are actively managed to beat its benchmark. Such active management of fund does not always ensure the scheme outperforming its benchmark. As compared with actively managed scheme, index funds are passively managed funds where the fund manager just imitates the parent index by investing in various companies in the same ratio as in the parent index.
As index fund is passively managed it does not have to hire an expert. The process of buying and selling can substantially be automated. It only involves the execution part of buy and sell decision, which does not cost much in terms of money. The index fund just replicates the parent index, so it does not have to trade more frequently ensuring minimum transaction costs as well. Such savings in overall costs help the index funds to have significantly lower expense ratio against actively managed funds. It helps the index funds boost returns compared with actively managed funds.
As per the efficient market hypothesis (EMH) theory, one
cannot beat the market consistently without raising the risk levels. The markets in developed nations are more transparent and the dissemination of information is quick and proper compared with developing countries like India. This situation will improve in due course and the actively managed funds will no longer be able to beat the broader market index funds due to higher operating costs.
In addition to being cost efficient, the index funds are tax efficient as well if held for more than 12 months when it is treated as long-term and are exempt up to Rs 1 lakh and taxed at the rate of 10 per cent on balance profits. Any profit made within 12 months is taxed at the flat rate of 15 per cent.
The exit load on actively managed fund is 1 per cent if redeemed within one year but the exit load on index fund is may or may not be levied if you exit between first day and 30th day. The lower lock-in period in index funds gives you the opportunity to play in the market without actually taking any direct exposure to specific security.
A tracking error
The index fund has to deploy its funds in the stocks in the same ratio as in the parent index. Thus, logically it should give exactly the same returns before expenses ratio. But the return of index scheme deviates on both the sides due to the need to maintain some cash to meet redemption demand. This difference in return is called tracking error. Lower the tracking error better the fund’s performance. So the best index fund is one with zero tracking error. Even positive tracking error is not good as it reflects on calls taken by the fund manager on the market, which he is not expected to take.
Who should invest
Index funds as a product are ideal for investors who want to reap benefits of inherent potential of equities to give better returns in the long run without having to churn their portfolio. The index funds are also ideal for the people who do not want to take the risk associated with a fund manager. In case of an index fund you need not worry about the fund manager as manager does not have any major role in performance of an index fund.
Your type of fund
Since there are many index funds tracking various benchmark index, a layperson faces the problem of plenty. So, for a lay investor who wishes to invest for long tenure goals like retirement or child education should invest in an index fund covering the broader market only and not in sectorial or thematic schemes as these are restricted to specific segment, theme and industry like midcap or smallcap or sectors like banks, consumer durables, health care, information technology.
Also, it is advisable to diversify the investment through broad-based index fund. A broader index fund provides broad market exposure with low operating expenses.
While selecting an index fund in particular category, please select the index fund scheme with lowers tracking error, which reflects the efficiency of the operations of the fund.
(The author is a tax and investment expert and can be reached on firstname.lastname@example.org)