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Why Invest in an Index Scheme of a Mutual Fund?

One knows that a risk averse investor plays safe while making his investments. Taking risks is not his cup of tea. Equity diversified mutual funds and shares are a strict no no. The statutory warning on mutual funds “mutual fund investments are subject to market risk, please read the offer document carefully before investing” is a turn off. There are several questions a risk averse investor would ask which causes him to hesitate picking up an equity diversified mutual fund commonly called an actively managed fund. The minimum term period one is advised to stick to equities in order to make a profit is three years. Fund managers are known to have an average shelf life of one to two years. Even if a fund manager is very good and has actively managed the portfolio well he might exit the Company at a crucial juncture for a better offer. The what if factor pertaining to the fund manager is a valid reason if one is a risk averse investor to think twice before leaping into the World of equities. But should a risk averse investor look towards an index fund which is passively managed and doesn’t carry these risks?

What is an index scheme of a mutual fund?

An index fund is basically an equity fund that mirrors or replicates a particular stock market index such as the CNX Nifty also called Nifty 50 or the S&P BSE Sensex. An index fund which tracks the S&P BSE Sensex will invest only in the thirty stocks which this index comprises of. The proportions of investment in each stock will exactly match with the weight of the stock in the index. All the fund manager has to do is to follow and replicate the index he tracks and invest in all the constituent shares in the same proportion or ratio as the index. Since there is not much a fund manager needs to do these funds are called passively managed funds. Since an index fund tracks a particular index and merely replicates its performance it can never outperform this index. One needs to keep an eye on what is known as the expense ratio in an index mutual fund. An index fund by virtue of being a passive fund incurs very low fund management fees. Since they replicate a particular index and buy and sell stocks based on its movements the transaction costs tend to be lower than an actively managed fund. In India the expenses of index funds are in the range of 0.5% and capped at 1.5% of the corpus or funds managed. Another important factor in an index mutual fund is the tracking error. One has the standard deviation which is a measure of volatility of the mutual fund. The difference between the standard deviation of the benchmark index and the fund is called the tracking error. Ideally there should not be a tracking error of more than 5% if the fund wants to be known as a good index fund. One must always choose a fund with a low tracking error and a low expense ratio as a high expense ratio means greater are the chances of a higher tracking error.

How can one measure the performance of an index scheme of a mutual fund?

One needs to compare the performance of an index mutual fund against the index it traces over a period of time. There are two methods to measure the performance of an index mutual fund mainly vis a vis the market indices it tracks and the category average. One knows that the returns of an index mutual fund must be in line with the index it traces. An allowance is made for the tracking error which must be within the range of 5%.In certain cases there is a shortfall in returns of more than 10% between the index mutual fund and the index it traces. The benchmark index might give a return of 50% in a couple of years while the index fund might give a return of only 40% resulting in a shortfall in returns as high as 10%.This is an indication that something is severely wrong in the management of the fund. There have been cases in which index funds have over performed the indices they track. While one might consider this as a good indication the reason this could have happened is that the fund was actively managed instead of passively following the index it traces in line with its stated commitment. One needs to note that both underperformance and over performance of the index fund vis a vis the index it traces is an indication of bad performance by the index fund. Under category average one compares the performance of the index fund versus other index funds with similar objectives.

  • If one invests in a pharma fund then one must trace the benchmark index which may be the BSE healthcare index or if one invests in a technology fund then one must compare its performance against BSE IT index.
  • If one is comparing the performance of an index fund vis a vis the index then one must compare this over a long term ranging from 1-3 years.
  • Mutual funds as per SEBI guidelines disclose the performance of the index schemes in the last 6 months as well as the past 1-5 year time period and also since their schemes were launched in both the offer document as well as in the half yearly results. As per recent rules they now need to disclose the performance of the index they track along with the performance of the index fund in the offer document as well as in the half yearly results. This enables customers to make an informed decision weighing the performance of the index fund versus the index it tracks.
Name of the index used as a benchmark Funds which trace this benchmark
BSE IT Index IT Funds
BSE Healthcare Index Pharma Funds
S&P CNX Nifty and BSE Sensex Balanced , diversified and tax planning schemes
Liquifex Liquid funds
Balance EX Balanced Funds
MIPEX Monthly Income Plan schemes

Why invest in an index scheme of a mutual fund?

  • Index funds operate with very low expenses when compared to the actively managed funds. This is because they are passively managed and just have to replicate an index. This results in a huge cost saving compared to an actively managed fund. The fund managers do not have to use complex techniques and models to predict the economy as in the case of the funds actively managed by their counterparts. Active management of funds can be a double edged sword for the fund manager as he has to constantly outperform the index. He is greatly rewarded if he succeeds but failure is not tolerated. This is a problem not commonly faced by a fund manager who passively manages a fund.
  • In an actively managed fund the fund manager might choose stocks which seem attractive but are not in line with the funds goals. There is also a chance in which a large number of stocks of the same or similar industry might be picked up in the portfolio resulting in huge losses in a market downturn. This problem is solved in an index fund as diversification benefits help to offset the downfall in the market.
  • In an actively managed fund such as an equity diversified fund pressure on the fund manager to give stupendously high returns leads him to take undue risks. If the fund manager pulls it off it looks great. If he fails the investor suffers huge losses. An index fund might not give very high returns in a short period of time but it is a consistent performer over long time periods.
  • Index funds are good for risk averse investors. This might translate to a one time investment decision. The fund manager only replicates the performance of the index with minor corrective action to change the exposure of the portfolio in line with the index besides addition of new money or the withdrawal of funds.
  • Index funds never leave ones cash idle without investing. An actively managed fund such as an equity diversified mutual funds manager might set aside funds up to 10% of the portfolio for hot stocks. Money needs to be kept handy as many investors exit the market in bad times. These are perform or perish funds and the exits can be quite nasty for the fund manager with investors making a beeline for the exit in bad times.
  • One can easily choose an index scheme of a mutual fund. One needs to identify the asset class he wishes to invest be it a pharma fund or an IT fund. One then picks the best index scheme in the asset class. This does not hold true in case of an actively managed equity diversified fund where they are hundreds of schemes of several equity diversified mutual funds.
  • These funds are a popular recommendation of financial advisers, economists, pension fund managers and great investors of many nations.

How are index schemes of equity mutual funds taxed?

If an index scheme of a mutual fund is sold at a profit the gains are known as capital gains. This is basically the difference between the purchasing price of the index scheme and the selling price of the index scheme which may be a positive value resulting in a gain. If the index fund is held for a period less than 12 months the gains are taxed as a short term capital gain. These short term capital gains are taxed at the rate of 15%.If the index funds are sold after a period of 12 months then the gains are called long term capital gains. These long term capital gains are exempt from taxes. This serves as an incentive for one to hold these index funds for a longer period of time and profit from capital gains.

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