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Invest in index funds for stability in mutual fund portfolio

Invest in index funds for stability in mutual fund portfolio

Index funds do not promise benchmark-beating returns, but their low-cost, low-risk fund management lends stability to your portfolio.

If you want to invest in equity mutual funds but are not confident about the abilities of the fund managers, index funds are a good option for you. Index funds are equity funds that replicate a particular equity index by investing in the stocks that the index tracks.

As each stock has different weightage in an index, the portfolio of an index fund is also allocated in a way to mirror that of the index. For example, if Reliance Industries has a weightage of 10% in an index, a fund based on the index would also allocate 10% of its portfolio to the stock.

No fund manager risk: This strategy of building an equity fund portfolio, called passive fund management, nullifies the risk associated with a fund manager, whether it be the possibility of quitting the fund or taking wrong investment calls.

Slow but Steady
Krishnamurthy Vijayan, managing director and CEO, IDBI Mutual Fund, says that index funds are independent of the competence of a fund manager, his longevity or his character.

According to Jaya Prakash, head, products, Franklin Templeton Investments, India, index funds are ideal for investors who prefer to take only market risk and not a fund manager risk.

Lesser portfolio churn: As the portfolio is based on a particular index, there is less churning of the portfolio, thus saving on the brokerage and transaction cost.

Low expense ratio: With limited role of fund managers, the fund management charges are also lower in index funds as a result of which the expense ratio is lower than that of actively managed funds. The average expense ratio of actively-managed fund is 2-2.5%, while it is 1-1.5% in case of index funds.

Traded on exchanges: Usually, normal funds can be bought and sold only at the net asset value (NAV) declared at the end of the day. But in case of index funds that are traded on exchanges, one can buy and sell anytime of the day at the price prevailing at that particular time. This way, one can take the price advantage not available in nonexchange-traded funds.

PERFORMANCE COMPARISON

Despite the above benefits, index funds lag many actively managed funds in terms of returns. In the three-year period up to March 31, 2011, the returns given by the non-sectoral index funds are in the range of 3-12% with only two schemes - HDFC Index Sensex Plus and Nifty Junior BeES - out of the 22 funds with more than three years of existence giving double-digit returns. (See table: Top 10 Index Funds)

1.5% of the total asset under management is the upper cap on the annual expenses an index fund can charge from Investors.

2.5% of the total asset is the upper cap on the annual expenses an actively managed fund can charge from Investors.
The difference in returns from the respective index (also called tracking error) is due to fund management and trading cost, time-lag in collecting and allocating the money and holding high cash at times.

If we compare this to actively managed equity funds, over 80 such funds gave over 10% annualised returns, with the highest being 23% by ICICI Prudential Discovery Institutional during the aforesaid period.

Though during the same period, 20 actively-managed equity diversified funds also posted negative returns, no index funds posted negative returns during the period. In fact, none of the index funds gave negative return in the 1-year, 3-year and 5-year period to March 31, 2011.

This shows that though the upside is lower, index funds can also limit the losses caused by the fund manager's wrong calls. Most financial planners and mutual fund experts though believe that it would take some time for index funds to become popular in India as there is scope in the country for actively managed funds to beat the benchmark indices consistently.

"Returns from index funds are smaller compared to other diversified equity mutual funds, and investors generally avoid these funds. It has been proven that some random stocks could beat market returns," says Joseph Thomas, head, investment advisory & financial planning, Aditya Birla Money.

Sumeet Vaid, founder and CEO, Ffreedom Financial Planner, says that Indian equity markets are less efficient than the developed markets in terms of uniform flow of information about particular companies and stocks. "This offers opportunity for fund managers to find stocks that can beat the benchmark indices consistently," he adds.

Index funds, despite their not giving ver high returns, can be a good option for investors who want to invest in equities but are still looking to minimise the risk involved in doing so.

WANT TO INVEST IN MUTUAL FUNDS? HERE ARE SOME HELPERS
1. How to choose best mutual fund
2. Best way to build mutual fund portfolio
3. Mutual fund managers share tips
4. Invest in SIPs in volatile times
5. 'Lack of investor interest in MFs worrying'
6. MFs with small assets under management do well
7. What goes behind awarding an AMC licence
8. Not a risk taker? Here's what you should invest in
9. Don't want a fund manager to guide you? Here's what to do
10. Invest in index funds for diverse portfolio
11. Review your MF's performance periodically
12. Mutual Fund Listing
13. The Annual Report Card