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Everything You Need To Know About Index Funds.
A Thread
A Thread
Let's begin with what is an index. A stock market index is created by selecting a group of stocks that represent the whole market or a specific sector/segment of market.
Eg: Nifty 50 represents major 50 companies of Indian stock market belonging to various different sectors of the economy. This index represents the whole market. Bank Nifty (sector specific index) is another index that comprises of all the major banks in India.
What are the Index funds? Well, The funds that invest their money in the companies that are part of a particular index.
Eg: a Nifty 50 Index fund will invest it's corpus in the stocks of Nifty 50 Index in the exact same proportion as that of the index. It will just replicate the returns generated by Nifty 50 index with a few exceptions, We will see them ahead in this thread.
What happens to the dividend received on the shares in the fund?
Dividends get reinvested in the same proportion as that of weights of stocks in the index.
Dividends get reinvested in the same proportion as that of weights of stocks in the index.
So why to invest in Index fund rather than investing in any other equity mutual fund?
Just like any investment, Index funds have their own pros & cons.
Let's find out
Just like any investment, Index funds have their own pros & cons.
Let's find out
Pros:
- Index funds are low cost, Fund manager has to simply buy shares in same proportion as that of index. Hence, He doesn't has to apply his skills or do research work. All of the money that is spent on research is saved & investors are benefitted with lower expense ratios.
- Index funds are low cost, Fund manager has to simply buy shares in same proportion as that of index. Hence, He doesn't has to apply his skills or do research work. All of the money that is spent on research is saved & investors are benefitted with lower expense ratios.
An active fund has expense ratio ranging from 0.5% - 2.5% however, an index fund would generally have lower expense ratio, Some of the index funds have expense ratio in the range of 0.1% - 0.2%. Lower cost means more return for investors.
- Index funds being passive strategy are not subject to personal biases of fund managers. Eg: a fund manager may have certain bias over a particular sector and may add more weightage to that sector.
This could lead to underperformance or outperformance, but, it would be solely dependent on fund manager getting his calls right. There is no bias in Index funds.
Cons:
- Lack of flexibility: Index fund managers have to be fully invested in index regardless of the market conditions. Other than for managing the liquidity of the fund, It cannot take cash calls or hold cash in it's portfolio to deploy when the opportunity presents itself.
- Lack of flexibility: Index fund managers have to be fully invested in index regardless of the market conditions. Other than for managing the liquidity of the fund, It cannot take cash calls or hold cash in it's portfolio to deploy when the opportunity presents itself.
Here is a snap from Scheme information document on an index fund. As you can see, It cannot hold more than 5% in cash and that too is to manage liquidity of fund in case of redemptions.
Active funds on the other hand have flexibility to wait and watch for market opportunities by sitting on cash.
- Index funds also miss out on the expertise a fund manager can offer in managing the portfolio actively. A fund manager can not only contribute to a fund by generating more returns but can also help in reducing the downside risks of the fund.
- Tracking error: This is an important part of index funds, Even when the fund managers try to replicate the index performance, there are issuing involved in matching the exact returns due to various reasons. These differences are called tracking errors.
Tracking errors arise due to following reasons:
1) Expense ratio: Even if it is lower, the index funds do have expense ratio and same is deducted from the NAV of fund. This also creates the difference between actual index performance and performance of the fund.
1) Expense ratio: Even if it is lower, the index funds do have expense ratio and same is deducted from the NAV of fund. This also creates the difference between actual index performance and performance of the fund.
2) Corporate actions: When the securities in the index undergo a certain corporate action, It could affect index fund in different ways. Eg: If there is a demerger & shares of a different company are allotted to the fund,
then it will have to sell those as they do not form part of index and then invest the money back in index constituents. This exercise maybe involve time gap and costs and this could create a difference between actual index value and value of index fund.
3) Cash balance: As stated in earlier post, index fund also has to maintain some cash position in liquid securities in order to handle redemptions. This could create some underperformance due to lower deployment of funds.
What are the factors to evaluate an index fund?
Two most important factors are:
1) Low cost: Pick the one having lowest expense ratio as lower expenses ratio will increase your returns.
Two most important factors are:
1) Low cost: Pick the one having lowest expense ratio as lower expenses ratio will increase your returns.
2) Low tracking error: Read the factsheet of the fund & try to invest in the one that has lower tracking error as that would be more closer to actual returns generated by Index.
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