In step with index

Index funds can be an option for first-time equity investors wanting to play safe, says Nilanjan Dey

The government's plan to allow select provident funds to invest in the stock market will unleash good tidings for index funds - long neglected by investors and intermediaries alike - provided investors exercise enough caution. An index fund invests passively in the securities of a chosen index with a view to replicating its movements.

Let's first go through the latest government proposal. Private provident fund trusts are being permitted to invest up to 15 per cent of their incremental deposits in equity or equity-related investments.

The labour ministry had earlier allowed the Employees' Provident Fund Organisation to earmark part of its corpus in equities. A separate notification has now been issued for private PF trusts or exempted establishments. The minimum base has been set at 5 per cent.

It is expected that the mutual fund industry - particularly index funds - will gain from the move. While companies listed on the BSE and the NSE, each with a minimum market capitalisation stipulated by the government, are also expected to benefit, the focus is firmly on funds that track the country's better-known indices. The BSE Sensex and the NSE Nifty are the two obvious benchmarks.

Potential inflows into index funds will help to swell their assets under management, which have generally stayed on the lower side. The average AUM of index funds is far too modest compared with actively-managed (and large-cap) funds. Incidentally, while a number of index funds do exist in the market, their range and variety are limited.

Passive yet effective

Index funds are a great way to step into the market for the first time. Such funds are very basic and convenient, thanks to their passive strategies.

The fund manager of an actively managed mutual fund picks stocks at will and in any proportion to prepare a portfolio. An index fund, on the other hand, will invest only in those stocks that make up a particular index. Moreover, the fund will invest in a stock in the same proportion as its weightage in the given index. Thus, an index fund simply wishes to mirror the chosen index in the best possible way. It does not attempt to outbid the performance logged by the index.

Hence, it is quite different from an actively managed fund, which tries to beat the index and outperform the broader market in the most optimum manner. It can, therefore, be said that indexing is for those who wish to test the market but not take too much risk while doing so.

Index tracking can be nearly a full-time pursuit for a serious investor. The choice in India, however, is rather limited - mostly Sensex and Nifty. However, the bank index has also attracted considerable interest because of exchange-traded funds (ETFs). There are quite a few lesser-known indices in the Indian market. Although these are all managed in a scientific manner, the market has largely ignored the lot.

The fact is intermediaries, including financial advisers, have really not attempted to bring their clients closer to index-based investing. In terms of commissions, selling index funds has never been quite a lucrative proposition. All these factors, along with a general lack of awareness, has tilted the entire domain of mutual funds towards actively managed funds, resulting in lopsided growth for the asset management industry.

Your strategy

Both active and passive style of fund management are available. Investors have to choose the one that suits them more. Here are a few distinct ways in which an investor can leverage index funds.

• Use a mix of styles. Apportionment should be a matter of personal choice. However, it should be done on the basis of one's appetite for risk.

• Place all capital gains derived from passive investment in carefully chosen actively managed funds. The entry strategy will then have a solid foundation. Any additional money that can be generated and spared should then be allocated to funds carrying extra risk.

• Utilise ETFs optimally. ETF is an index fund which is traded on the stock exchange. A smart investor who is not averse to the stock market should feel free to use ETFs. The latter can bring in an added element of volatility. Also, the choice of index is a very significant factor.

Tracking error

An index fund by definition has a simple investment objective: achieve returns which are very similar to that of the target index. So, it just tries to replicate the achievements of the target index by holding all the stocks in the same index. Yet, such a strategy is frequently at risk. Such risks often lead to a mismatch of sorts - the returns recorded by the fund do not exactly emulate, and indeed vary from, that delivered by the index.

This gap is known as the tracking error. Indices need to be closely monitored. An index fund with a lower tracking error is more desirable from an investor's standpoint.

A serious index fund investor must keep an eye on several key factors. Some of them are: inflows and outflows in the fund, alterations in the index (that is, changes in its constituents) and the kind of cash that is maintained by the fund (for liquidity management).

Further, expenses are a key element to watch out for. Expenses eat into a fund's overall returns. Transaction costs, for instance, are a big consideration in asset management. A fund has to bear a host of other expenses as well.

High expenses will result in a difference between the returns attained by an index and the returns delivered by its tracker.

The author is director, Wishlist Capital Advisors



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