Index funds - a good idea for a first time equity investor

My article on Index Funds in Gujarati Mid-day, Mumbai edition

http://epaper.gujaratimidday.com//epaperpdf/gmd/29122014/29122014-md-gm-12.pdf


The English translation is as under:

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Index funds

“What do you suggest for a first time investor in equity markets?”

One has seen many a first-timers start with penny stocks – the stocks of small companies quoting below Rs. 10. Some of these investors lose money, have a bad experience and then pledge never to return to equity markets. Some others make money in the short run and learn incorrect lessons – for example, some become overconfident about their skills. Some others lose money in the beginning, but learn the right lessons – by paying too high a fee to the ultimate teacher – the stock market. All these experiences are avoidable.

Someone entering the equity markets for the first time would be well advised to take the mutual fund route, learn about investing and then, if at all, try hands at stocks. However, even within the equity mutual funds, there are too many choices and it becomes difficult for one to make a good selection.

That leads to another set of questions: “Which fund manager is better?” “What if a good fund manager turns out poor performance?” well, to make things simpler, one may consider investing in an index fund. In this way, there is no question of selection or fund manager performance. How does an index fund work?

An index fund is designed to track the movement of a market index. This makes it easier for an investor to track the portfolio performance. For example, a fund tracking the popular index Sensex would move in line with the movement of Sensex. If Sensex moves up by 10%, the fund’s NAV should also move up by around 10%. We mentioned the word “around” in the previous line, since there would always be some difference between the performance of the fund and the index. This difference is called “tracking error”. A good index fund would have low tracking error.

Though there are many factors contributing to the tracking error, one important factor is the expenses charged by the mutual fund company.

SEBI has prscribed limits beyond which a fund cpompany cannto charge the scheme. For index funds, the ceiling of expenses is lower than than the actively managed schemes. The reason for this is simple: in an index fund, there is no role of a fund manager in selection of securities to buy/sell or the timing of such decisions.

An index fund could track a popular index like Sensex or Nifty, or it could track a wider index like S&P 500. We also have index funds tracking an industry – Bank Index or a PSU Bank Index. There are funds in the Indian market that help investors invest in international markets, e.g. NASDAQ, Hang Seng, etc. In developed markets, there are index funds tracking even the bond indices.

Today, with the available variety in this segment, an investor can conveniently and cheaply get exposure to variouis different segments of the market or different markets.

While selecting an index fund, one should consider the following points:

1.     The index being tracked,

2.     Tracking error of the fund – this indicates how the scheme has been managed in the past – lower the better

3.     Expense ratio – this would contribute to the future tracking error – lower the better

There is no need to look at any other factor while selecting an index fund.

In the end, let us consider the question regarding out- or under-performance. Will an index fund generate superior returns over actively-managed funds? The answer is very clear. The index is nothing but an average and an average will always generate average performance.

There will always be some funds that will do better than the index. The problem is that it is almost impossible to identify future winners in advance.

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.

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