Track the index

Predicting which sectors or stocks will do well this year will be quite impossible,so go with an index fund

Written by Prasunjit Mukherjee | Published:March 9, 2009 1:42 am

“The markets are going to turn around some time by the middle of the year.” “The markets are headed nowhere for a long time and that is where they are going to stay.” By and large,most equity investors,fund managers,and others of their ilk adhere to either of these two positions. But isn’t there a large middle ground between these two positions,or has the extreme optimism generated by the recent bull market,or the extreme pessimism of the last one year made us believe that the market only moves in extremes? For those who believe in the middle ground and think there is money to be made in the market this year,the right vehicle might be an ‘index fund’.

So,what is an index fund? These funds are passive followers of an index,i.e.,fund managers do not take active calls in managing the assets of these funds. These funds invest in stocks that constitute the index and attempt to mirror the proportion or weightage of the stocks in the index. However,because of certain limitations like time,technology and availability of scrips,the quantum of representation of scrips in such funds is not exactly the same. A degree of variation exists,which is termed as the tracking error. Technically,the fund is a proxy to investing in the chosen index,be it the Nifty or the Sensex.

Types of index funds

These funds can be of two types — plain vanilla index funds or exchange traded funds (ETFs). In the first instance,the fund units are issued and redeemed by a mutual fund house.

In case of an ETF,the investor buys and sells units in the open market (the stock exchange) via a broker. Depending on availability,he gets to buy and sell the desired quantity. The difference between these two lies in the route employed for making a transaction. The index need not necessarily consist of stocks: in India you get index funds and ETFs based on stocks and gold,but in some markets you can also buy index funds and ETFs based on commodities,real estate,and precious metals. More than 15 open-ended domestic index funds and about 10 domestic ETFs exist in the Indian market (see table).

Why aren’t they popular?

So why aren’t index funds and ETFs as popular as actively managed peers? The answer is — because of all of us. Manufacturers (read fund houses) don’t push them aggressively enough; distributors see no need to push them as the margins are lower compared to that offered by equity funds; and investors are unaware of them or largely ignore them as active fund managers are perceived to be beating the index. However,if we take into consideration the entire investment cycle,we would be surprised to find that index funds have largely beaten the performance of the more celebrated active funds. Also,the index fund category is the largest category of funds in the world.

It will be quite difficult to predict which sectors will lead the next bull run or the stocks that will be in favour. Confronted with this dilemma,what should an investor do? Buy into an index fund. It will largely mirror a chosen index,charge much less than an actively managed fund,and is more convenient to enter,or switch into a cash fund,or move out into cash altogether.

My suggestion for the next year is to allocate upwards of 40 per cent of your portfolio into index funds. Open an account with a good company in an index fund and when you feel like it,shift from that account into a liquid fund or a cash account. The incidence of tax will be higher compared to long-term capital gain,but it will be at par with the short-term capital gain tax on other equity funds. But remember: capital gains tax happens when there is a capital gain and tax takes away only a part of your profits.

Let’s say the markets are at 9,000 on the day you invest and after a year they reach 10,500 (both Sensex figures). In case of an actively managed fund,you will be hard put to predict how many funds will generate the nearly 18 per cent returns generated by the index fund. But all index funds will generate that figure,or something quite close to it.

This is the year when smart money ought to be invested in index funds. u

The author is a Kolkata-based mutual fund analyst.

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