Investing in equity directly is a full time job and requires  relevant knowledge,  analytical skills so investing in index fund is a good option for a lay investor. Let us understand more about Index Funds.

1. What is an Index Fund?

Sensex Nifty are two major  equity indexes of two major stock exchanges for measuring and tracking the mood and movement of the market. There are many as many as 38 indexes on Bombay Stock Exchange. The primary purpose of any index is to reflect the price movement of  shares comprised in a particulars category or segment like large cap, small cap, consumer goods shares, bank shares etc.  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.

2. Features of an Index Funds

Most of the 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 to 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 people. 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 does not have to trade more frequently ensuring minimum transaction costs as well. Such saving in overall costs help the index funds have significantly lower expense ratio as compared to actively managed funds. It helps the index funds boost their returns as compared to actively managed funds.

As per the Efficient Market Hypothesis (EMH) theory one can not 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 as compared to 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 upto Rs. 1 lakh and taxed @ 10% on balance profits. Any profit made within 12 months is taxed at flat 15%.

The exit load on actively managed fund is 1% if redeemed within one year but the exit load on index fund is may or may not be levied if you exit between 0 days to 30 days.  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.

3. What is a tracking error and why it is there in the index fund  

The index fund has to deploy its funds in the stocks in the same ratio as in the parent index so logically it should give exactly the same returns before expenses ratio. However the return of index scheme deviate 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.

4. Who should invest in Index Funds

Index funds as a product are ideal for investors who want to reap benefits of inherent potential of equities to give better returns in 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.

5. What type of index funds one should invest?

Since there are many index funds tracking various benchmark index, a lay person 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, industry etc  like mid cap or small cap or sectors like banks, consumer durables, health care, information technology, 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.

Balwant Jain is a tax and investment expert and can be reached on jainbalwant@gmail.com

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