With index funds, choppiness won’t hurt

The passively managed funds are particularly good for building a milestone corpus Equity markets have undergone quite a bit of consolidation in the last few weeks. For a retail investor,stock-picking now seems much riskier than earlier.

That said, the low levels of current markets make many an investor wonder if they can enter at these levels. With a limited expertise in stock selection, it is a tough task to get the value buys right. Also, getting stuck to poor performers can be pretty disheartening when the bulls take charge of the market again.

Equity mutual funds, on the other hand, become somewhat unpredictable in their behavior in such turbulent times. Even if the investor wants to enter the markets at a certain level, the fund that he invests in might choose instead to stay put in cash. When taking a call on the overall market, therefore, index funds turn out to be a better choice for investments.

Index funds are passively managed funds and replicate the movement of an index like the BSE Sensex or NSE Nifty or any sector specific index without attempting to beat it. These will give the upside from the expected bull run in the exact proportion of the market movement and will not lag or lead the index. There is a common misconception that funds with a passive management style provide lesser returns as compared to actively managed equity funds. However, a large proportion of diversified equity funds underperform the index over long time horizons.

The following table shows the performance of equity mutual funds vis-à-vis the market indices.

Index returns (%) 1 yr 2 yrs 3 yrs

BSE Sensex 21.86 21.63 35.95

S&P CNX 26.08 21.88 34.18

NiftyCrisil Equity 17.46 12.49 28.65

Unfortunately, very rarely will you find any distributor recommending index funds, thanks to the low commissions they offer — another reason few people are aware that index funds so much as exist.

Most index funds have neither entry load nor exit load (beyond a minimum holding period), which ensures that the entire invested money is deployed in the equity markets. To add to this, the expense ratios are much lower for index funds ~1-1.5% and keep going down further as their AUMs increase. The composition of the target index is a known quantity; so the running costs are less for an index fund as no stock pickers or equity analysts are required.

One obvious disadvantage of index funds, however, is that they cannot outperform the broad markets unlike actively managed funds. However, for long-term investors who want to avail consistent gains and take advantage of the growth story in India without constantly churning their mutual funds portfolio, there is nothing better than an index fund. When it comes to building a corpus for milestones such as retirement, index funds are clearly a superior choice.

Index funds are offered by a majority of mutual fund houses like ICICI Prudential, Birla Sun Life, Franklin Templeton, HDFC, UTI, etc. All these are mutual funds and can be bought through mutual fund distributors. The Nifty BeES by Benchmark, though, is an exchange traded fund (ETF) listed on the NSE. To buy an ETF, an investor need to have a demat account and an equity broking account.

Unlike actively managed equity mutual funds, Index funds offered by different mutual fund houses do not vary in their returns significantly (see table: Index picks). Hence, the parameters to choose an index fund are different from those used for an actively managed fund. Expense ratio and tracking error are the most important factors while choosing an index fund. Expense ratio indicates the cost of investing in the fund and the tracking error indicates how much the returns of the index fund differs from its underlying index. Low tracking error and low expense ratio are desirable. Typically, higher AUM results in lower expense ratio. It also keeps an index fund stable and not prone to large withdrawals by major investors.