Index funds: Less risky way of investing in equity market

Mutual funds (MF) are instruments which are seen as passive investment vehicles to participate in the market opportunity at lower costs. The latter is seen in the context of the availability of expert and professional approach, regulatory framework and ease of execution. These features of the MF make the most convenient form of wealth creation for the retail and/or High Networth Individuals (HNI) investors. Whenever we mention about any MF, the first thing that comes to our mind are the equity funds especially of those which are active funds.

Active funds are the MFs where the fund manager actively manages the funds with a definitive and well-defined objective to generate wealth over a longer period of time. The idea is to generate a higher and/or better return than the defined or approved benchmark. This requires a consistent, if not constant eye on how the portfolio is responding to the changing market conditions; accordingly make variations to make better out of the situation. It could be either to reduce the risk and thus counter the possible fall or get better out of the opportunity and gain higher returns.

The fund manager backed by the research team allows them to keep tab on the fund portfolio and even churn depends on the requirement, which incurs costs which is reflected in the fund management costs, in-built in the NAV of any fund.

There are also passive funds which doesn’t require any kind of additional management in the portfolio. An index fund is a collective investment scheme that aims to replicate the movement of an index of a specific financial market, or a set of rules that are held constant, regardless of the market conditions. These are a type of mutual funds with a portfolio constructed to match or track the components of a market index, such as the Sensex or Nifty BeES. An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.

In general, they are seen as an economic and relatively less risky way of investing in equity. As the fund manager only has to mimic an index, there is not much churning of portfolio compared with an average actively managed diversified and/or any type of equity fund translating in to lower costs. The expense ratio i.e. the cost incurred by a mutual fund is thus lower in most Index funds.

If one chooses a CNX IT index fund then the fund invests its corpus in IT stocks in the same proportion as the CNX IT index. Like any other index fund, this fund would be fully invested to mimic the performance of the underlying index. If all index funds tracking the same index are expected to offer the same returns, then it is obvious that one should pick the one with the least expense ratio.

While investing in an Index fund, one should look beyond the expense ratio and hence consider the tracking error. The tracking error is the deviation between the returns generated by the index fund and the underlying index. A good Index fund has a minimum deviation from that of the index. But there is an important argument against the Index funds, especially with a lot of underperformance when compared to an actively managed fund tied to the same index.

Higher market capitalisation by a stock ensures its way into the index. In other words, when you invest in an index, Sensex per se, one would buy a basket of expensive stocks, thus moving away from the principle of value investing.

The returns thus earned from a stock are a function of its purchased price, so, higher the purchase price, lower the returns. As one buys the index, the returns could be sub-optimal. This could be damaging with the stocks in the index being churned i.e. existing ones moving out and being replaced by another stock.

Also, the trouble with index investing is that there is no way to benchmark the performance of an index (since the index is itself the benchmark). Whatever the returns from the index, the investors have to accept without question as what they have got is the market return. In the US, these form about one-fifth of the entire MF assets but recent comments from Bogle, founder of Vanguard who popularised index investing has cautioned about overdoing of these funds by the investors.

His contention was that - If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large US corporation. One outcome is that large passive investors may not be as invested in the performance of a single company as asset managers who have more riding on the performance of one company. In that scenario, they may not exert as much oversight and pressure as active investors.

The next question is which index fund you should invest in - sectoral, broad based or any other on offer? If one is looking for long-term wealth creation a broad-based index like Nifty or Sensex would help. And investors with long-term horizon could add a dash of such funds to the portfolio and also those who expect a particular sector to do well could gain from this kind of exposure.

(K Naresh Kumar - The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at knk@wealocity.com)