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Bang on track

Index funds mimic the markets and match its performance. But are they good investments?

Clifford Alvares | Print Edition: February 10, 2008

Jayant Pai, Financial Planner
Jayant Pai
While the stock market has been rising for much of last year and for a few days into the current year, the question after the recent loss of over 2,000 points from its peak is: will the markets have a smooth sailing ahead? In the early part of last year, the market was steady, but soared in the latter half on increasing fund flows.

And one category of mutual funds that did well along with the widely followed broad market indices was the index funds. On average, index funds got a profitable ride on the rising Sensex, returning about 49 per cent and making them a good investment avenue for those who invested in them.

But now, market strategists are waving the danger flag to investors saying the passive ride might not be a smooth sailing one this year. The recent selloff by foreign institutional investors on concerns of the slowing US economy has seen the market plunge 2,000 points, or about 10 per cent from its recent highs.

 
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If the indices cut back further, index funds are the ones that will lose out. It’s not to say that diversified funds, by contrast, will not lose; some could, particularly those that are exposed to stocks that are hard hit by the sharp unwinding. But if the market is going choppy, it’s better to remain in stocks that have growth potential.

Index funds perform very well in a market that is booming and is a cheaper way of investing compared to the diversified and actively managed funds that have a higher expense ratio.

But over the last year, index funds have been lagging behind the actively managed funds by some margin. On average, actively managed funds raked in about 60 per cent return, which is about 13 percentage points higher than index funds.

Keeping up with the market

Index funds allow you to buy the market at its current levels.

  • They track the broad diversity of the stocks and sectors in the index

  • They work on the principle that it's best to follow the market, than try and outsmart it

  • Index funds have a low cost as they do not require active monitoring

  • They aim for market returns by investing in stocks in proportion to a major index
As of now, there are only fewer index funds and they are based on either the Sensex or the Nifty. There are a couple of sector funds and exchange-traded funds that mirror the Bank PSU index, but they are just a handful.

So, most of the index funds in India mirror the basket of stocks that are represented in the broader indices, and most of these stocks are large caps.

But the market comprises many other stocks in the mid- and small-cap space. Says Yogesh Kalwani, Senior Vice President (Products), Motilal Oswal Securities: “Index funds are based on market cap or the fleet float norm. There are more than 80 stocks with a market cap of Rs 20,000 crore. So, there’s no point in cutting it very fine in index funds. There are opportunities beyond that.”

Good for passive investor

But this category of funds is a good idea for those investors who simply want to track the market, and want to keep their expense low. Besides, it’s a passive way of staying invested in the Indian growth story, which is expected to expand at around 8 per cent and more in the coming years.

Says certified financial planner Jayant Pai: “Many actively-managed funds find it increasingly difficult to beat the market. If you are new to the markets, it’s the lowest cost play. So, you can allocate some portion to index funds.” Pai also says that it’s difficult to consistently choose the outperforming funds.

Yogesh Kalwani, Sr VP (Products), Motilal Oswal Securities
Yogesh Kalwani
An index fund, by its very strategy of remaining invested in some of the well-represented and bigger sectors, does well when the index performs.

Over the coming months, however, the index is going to get volatile. Hence, invest in index funds only if you are going the long haul and want to remain a passive investor.

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