How Good Are Index Funds At Chasing The Riches of The Sensex?

By | June 1, 2016

Index Funds

When investment guru Warren Buffet speaks, investors across the globe sit up and pay attention. And, that’s exactly what happened recently when Buffet threw his weight behind index funds. The oracle of Omaha noted that these funds could bring handsome returns. But, the Indian investors had only one question: will Buffet’s statement hold true in Indian market conditions?

Before dissecting the pros and cons of index funds, let’s see what these funds are.

Index funds are a kind of Mutual Fund with a portfolio created to match or track the elements of market indices such as the Nifty or Sensex. As one might be aware, each stock has a weightage in a market index and the portfolio of an index fund is weaved in a manner that mirrors the index.

Index funds versus actively managed funds

In a face-off between index funds (or passive funds) and actively managed funds, the striking difference is the absence of fund managers in the former. In the latter, professional fund managers play a pivotal role in choosing the stocks, securities, or bonds to meet the fund’s objectives.

Difference in costs

It costs less to manage an index fund compared to an actively-managed fund that requires regular trading. Managed funds attract brokerage fees and transaction costs, unlike index funds. The average expense ratio of index funds is less since these do not require fund managers. The expense ratio of managed funds is 2 to 2. 5%, while that of index funds will be in the range of 1 to 1.5%.

Slide factor

When the market falls, passive funds also fall. In managed funds, the slide can be arrested to a certain extent by retaining only performing securities. As the index funds mirror the market, falling and rising with the market is inevitable.

Trade factor

Index funds can be bought and sold at any time as they are traded on exchanges. Through this, a trader could also take advantage of real-time prices. But, Mutual Funds can be transacted only by the net asset value (NAV) declared at the end of a trading day.

Index funds and Indian investors

In India, index funds form a minuscule chunk of the larger Mutual Fund industry, and these funds are still in a nascent stage. Moreover, Indian investors may prefer actively managed funds which have the potential to bring in good returns.

What to look for

Whether an index fund is a hit or miss is gauged by the extent of its index-tracking error. The fund is a hit when the tracking error is low and a miss when the error is high. The tracking error is measured by how closely the fund is able to ape the performance of the index it is mimicking. It is also advisable to go for a broad-based index fund.

Index funds, though not a high-return option, can augur well for investors in India who want to invest in equity markets with low risk. These funds could be beneficial for greenhorns in equity investment, as index funds will give them exposure to a large broad-based portfolio at a low cost.

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