Basic Concept
An Index Fund is a mutual fund which will match the performance of an index, for example, like Sensex or the Nifty. It is a passively managed fund. On the other hand, an actively managed fund seeks to outperform an Index, that is, deliver a performance better than that of the index.
The index fund basically does this by investing in the stocks of the index in percentage of their weights. For example, a fund which tracks the Sensex will invest in the 30 stocks of the Sensex in proportion to the weights of the stocks in the Sensex. Alternatively, if an index has say 100 stocks, the fund manager will select a sample of stocks of the index which will match the index returns. This is done by sampling techniques, historical data research etc.
Since the fund has to just mirror the index, there is no research or stock selection issue, hence the fund is known as a passive fund.
Market theory Behind
The reason why people believe that funds should be passively managed is the efficient market theory. As per this theory, the prices reflect information to the extent that the cost involved in collecting information on stocks is more than the profits from it. The hypothesis implies that fund managers and stock analysts are constantly looking for securities that may out-perform the market; and that this competition is so effective that any new information about the fortune of a company will rapidly be incorporated into stock prices. It is postulated therefore, that it is very difficult to tell ahead of time which stocks will out-perform the market.
Advantages
Low Cost: Since the funds are managed passively and most of the modelling for investing is done by computers, the fund costs are very less compared to actively managed funds. In India, it is around 1%.
Lower Turnover: Passively managed funds have lower turnover, meaning that there is less buying and selling of stocks since their portfolio composition doesn’t change a lot with time. This result in lower brokerage costs, capital gains tax etc.
Lesser Risk: Compared to actively managed Portfolios which invests in relatively fewer stocks an index fund invests in more stocks thus reducing risk. Also you are not exposed to the risk of fund manager performance. Fund manager’s under pressure to meet targets may take aggressive positions which results in losses.
Beating Markets is not easy: In the long run getting returns above that of the market is not easy due to the factors mentioned above. For example, in mature markets 80% of funds underperformed benchmark funds.
Exchanges act as Your Manager: In a passive management fund you effectively allow the exchange to act as the manager. The exchange change stocks in the index based on performance, state of economy sectoral factors etc. Since Exchanges are managed by some of the savviest investors you are utilizing their services for free.
Disadvantages
Tracking Error: Since a fund has to have cash to meet redemptions, there will be some underperformance or over performance with respect to the index. Also, due to factors like change in composition of index or due to change in weights of companies owing to mergers, the performance of index funds generally is around 1-2% lower than index funds globally.
No Outperformance: The Index Funds are limited to produce returns less than equal to the Index. While, returns above index have no possibility.
Distortion in Stock Prices: Stocks which leave the index are beaten down because of index funds selling and stocks entering rise due to buying by index funds. This distorts the prices of index funds above fair value due to liquidity.
Lack Of Market Efficiency in Emerging Markets: Emerging markets are generally less efficient than mature markets due to volatility associated, more information gap, less investment and research activity etc. Under this situation, active funds may be better.
The Indian Scenario
In India, the popularity of index funds is extremely low. For example, in 2009, of the total equity investments, less than 1% was in index funds. There are many reasons for it. Like, in India for most people who invest directly, it is a passion and they take it seriously. While in the category of those who prefer mutual funds, there is lack of knowledge of the benefits of Index funds. Also, since the margins are lower in Index funds, most mutual fund companies don’t promote it as much to investors. Lastly, India being an emerging market there is more opportunity for a fund manager to pick up hitherto unknown stocks and beat benchmarks.
But despite all this, if you are an Investor with a sufficiently long term horizon of 20yrs and your risk appetite is low it makes better sense to invest in index funds. Because in the long run all the tax, broking cost and averaging out factor should favour passive funds. For Pension funds, Life Insurance companies and other long term funds, index funds are a better option. Also, the situation in India seems similar to that US in 1970s, when Index funds were launched in US and there was a lot of scepticism. Now, 25% of all equity investments are in index funds in the US. Similarly, the investments in India will and should increase.
There is a bright horizon for index funds in India and long term risk averse investors should go for it.
References
By - A.D. Dheeraj (pgp01001.iimrohtak@iiml.ac.in)
