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Sunday, June 16, 2013

What are Index Funds in India

In this series of posts, we are studying about various kinds of mutual funds available in the Indian market. In the last post, we studied about Income Funds. Today, we would study about another important category called as Index Funds.

What is an Index Fund?
An index fund or index tracker is a collective investment scheme (usually a mutual fund or exchange-traded fund) that aims to replicate the movements of an index of a specific financial market.
Index Funds today are a source of investment for investors looking at a long term, less risky form of investment. The success of index funds depends on their low volatility and therefore the choice of the index.

What is an Index?
An index is a group of securities that represents a particular segment of the market (stock market, bond market, etc.). Among the most well-known companies that develop market indexes internationally are Standard & Poor's and Dow Jones.

What is the composition of an Index Fund?
Index funds will hold almost all of the securities in the same proportion as its respective index. Index funds can be structured as a mutual fund, an exchange-traded fund, or a unit investment trust.

What about Fund Management Fees?
Since the index fund directly tracks the index composition, it does not involve active fund management. The lack of active management generally gives the advantage of lower fees (which otherwise reduce the investor's return)

Tracking Error
The difference between the index performance and the fund performance is called the "tracking error", or, colloquially, "jitter". This is usually because of the administration fees or time delays in tracking.

Some Common Index and associated Funds
ICICI Prudential Index Fund  - tracks Nifty index
HDFC Index Fund Nifty Plan - tracks Nifty index

Why are Index Funds not as popular in India?
In spite of low cost and low risk, Index Funds in India are not as popular in India as they ought to be. Why?
1) Globally, it has been witnessed that as markets become more efficient, it becomes harder for fund managers to beat their benchmarks. Passive funds progressively become the preferred investment vehicle in such markets. In the Indian market's most efficient segment, the large-cap space (funds with more than 80% allocation to large-cap stocks), passive funds have a significant presence.
2) Today, returns from index funds are smaller compared to other diversified equity mutual funds, and investors generally avoid these funds. It has been proven that some random stocks could beat market returns
How should to choose best index funds in India?
1) Expense ratio: Since there is no research or higher management costs, the costs of index fund should be relatively low. E.g. for IDFC Index Nifty fund, the expense ratio is 0.25% and followed by Reliance Index Nifty fund at 0.40%.
2) Tracking error: If all the Index funds tracks the same index, then every index fund should offer the same return. Then our choice is to pick-up a low expense ratio. However you also need to check the tracking error. The returns generated by an index fund may vary due to returns generated by underlying index. This deviation from index fund returns is called tracking error. Generally low tracking error funds are good. 


Manoj Arora
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