Index Funds are designed for the passive investor to invest in the stock market. Should one invest? ADITYA PARIKH tells you.
Passive investors tend to be wary of the stock market. They believe if they don’t hawk over their equity portfolio, if might fly away. So many choose the safety of debt instruments and simply skip the stock market entirely. But soon, on opening the business page of a newspaper that declares that the SENSEX has hit a new high, the emotion of safety rapidly moves towards regret. Most passive investors want join the ride, but aren’t sure how to. Index funds endeavour to provide the ticket to jump onto the index ride.
Index funds are mutual funds designed to mirror an index. In simple words, it is a fund that tries to passively replicate an index e.g. SENSEX, NIFTY. So, if the SENSEX, for example, has a 20% weightage of Reliance Industries and 15% weightage of Hindustan Unilever; then this fund too will try to have the same proportions and weightages. From an investor’s perspective, it’s a passive way to mirror the returns of the SENSEX or NIFTY for one’s
Index funds have been around since the 1970s in the USA, and the concept has only spread over the years. Worldwide they track indices over all asset classes may it be equity, commodities or debt. In India, most equity index funds track the NIFTY or SENSEX. The popularity of the SENSEX and NIFTY makes these funds easy to understand to a lay investor. The passive investor can easily judge the trajectory of his investment, by simply opening the business page of a newspaper and seeing where the SENSEX is headed. According to Tilak Wankhedkar, Partner- Exclusive Banking, Indusind Bank, index funds are recommended for conservative investors, mostly people who want to mirror the returns of the index.
The SENSEX has delivered a compounded average return of around 21% over the last three years, squarely beating inflation. This means capital grew and generated real returns. So, roughly three years back, if one had simply invested in an index like the SENSEX, gains made would be without any active stock picking or analysis. It’s just lazy piggy-backing the SENSEX, hence the phrase passive investments. Talking about passive investments, Ronak Morjaria, Certified Financial Planner, says, “index funds would be advisable for people don’t want to review their portfolio often, and would just like to take the benefit of equity returns.”
However, there is no free lunch. All mutual funds have various expenses and charge for it. All these expenses when expressed in percentage form are called an expense ratio, and this figure should be available in the fund’s fact sheet or other documents. Usually compared to actively managed funds, passive index funds have fewer expenses. In expense ratios, like all costs in life, lower the better.
Even replicating, sometimes isn’t a perfect art. There is concept called tracking error when it comes to index funds. Fund managers of actively managed funds attempt to beat the benchmark, while passively managed ones endeavour to mirror it. However, the effort to mirror can be extremely close, but not exact. So, the tracking error is a measure of that difference in mirroring. And like the expense ratio, lower the better.
As of December 2014, the tracking error on the SBI Nifty Index Fund is approximately 0.29% and on the ICICI Prudential Index Fund- NIFTY is 0.55%. CRISIL for the quarter ended December 2014, has ranked SBI Nifty Index Fund at number three on its index fund ranking and ICICI Prudential Index Fund – NIFTY Plan at number four, thus emphasising the importance of tracking error.
Therefore, the two most vital statistics while deciding which index fund to pick would be the expense ratio and tracking error. A third number to consider would be the size of the fund, if the fund size is too small, it can be avoided. Besides number crunching, a qualitative assessment like reputation of fund house should be given importance as well. CRISIL has an index fund ranking list, which could assist the decision on fund choice.
Putting all eggs in one basket has never been prudent. Tilak Wankhedkar, Indusind Bank suggests that one should invest about 10% of one’s equity portfolio in index funds and preferably a NIFTY index fund. Also, instead of investing in one lump sum, Ronak Morjaria, Certified Financial Planner, advises, “it is better not to try to time the market and instead invest via the SIP method with a six to seven year horizon.” And his top three picks in index funds are HDFC Index Fund- Sensex Plan, IDFC Nifty Fund, HDFC Index Fund- Nifty Plan.