Risk-averse should take the index fund route

Unlike actively managed funds, index funds eliminate fund manager risk

Taking a call in volatile stock market conditions isn't easy. But for long-term corpus building, equities need to form a part of your investment strategy call. Other asset classes such as real estate and gold are good as diversifiers, but should not form the core of the portfolio.

And they come with their own set of issues. With the Consumer Price Index (CPI) - the indicator of what consumers are paying for their basket of goods - in double digits, investing in fixed income instruments does not really make much sense because the post-tax returns are in the region of seven to eight per cent. Real estate requires a huge capital investment. Gold, the favourite of investors for almost half-a-decade, seems to be slipping especially after the government and the Reserve Bank of India have come out with stringent guidelines.

It's not that equities are without their own problems. For instance, which sector does one choose? Or which stock in a particular sector is good? Even mutual fund investors have around 2,000 equity schemes to choose from. However, a safe and perhaps the simplest way of investing in equities is through an index fund. Index funds provide a low-cost and somewhat safer option. Also, the fund manager has to follow a template that is already existent, in terms of the index that the scheme is following.

So what is an index fund? It is an equity fund that replicates a particular equity index by investing in the stocks that the fund tracks. For example: An index fund can mirror either S&P Sensex or Nifty or BSE-100 and so on. Investing in index funds is a passive investment strategy as the investor attempts to mirror the returns of the overall market represented by the index stocks.

But before investing in them, look at two important parameters to choose an index fund - expense ratio and tracking error. Tracking error is the standard deviation of the returns differential between the fund and its benchmark. The objective is to choose an index fund with the lowest tracking error. The optimal index fund then is one, which has low tracking error and expense ratio. The low tracking error is considered good as the returns of the fund mirror that of the index. If the tracking error is high, it means the returns of the fund is not in line with index contradicting the very purpose of investing in index fund.

John Bogle, founder of The Vanguard Group and a major figure in the index investing community, was the first person to offer an index fund to retail customers. Bogle has long been a proponent of passive investing over active management, and for low fees and no sales charges. Considered the Father of Index investing, Bogle believe that the average investor cannot "beat the market" over time. Vanguard funds are renowned for their ultra-low expense ratios, and for having no loads. Vanguard 500 Fund carries a total expense ratio of less than 0.5 per cent of assets annually, and has outperformed the majority of mutual funds over the past 25 years.

Advantages of index investing:
Convenience: Since investors don't have to bother about the performance of specific stocks, it provides huge convenience for investors to have hassle free investing.

Low expense ratio: Since there is no active management of stocks, the expense on account of investing is lower. The expense ratio for index funds ranges from 0.5 per cent to 1.50 per cent whereas the expense ratio for active funds is 2 per cent to 3 per cent.

Churning of underperformer outdated stocks: Most of the indices consist of actively traded stocks. In case any stock is an underperformer or has low liquidity, it is automatically weeded out whenever the reconstitution of stocks in the index happens. Thus, these indices enable the investor to own stocks that are in vogue and remove the underperformers. Investors, then, need to worry about being invested in laggards.

Diversification of risk: Since you invest in a basket of securities, it allows you to have a diversified portfolio.

Disadvantages of index investing:
No outperformance: A small set of active fund managers will always outperform the indices. If you have invested in passive funds, don't pay too much attention to the active funds that have outperformed in a given year. Remember that the probability of correctly predicting next year's winners year after year is very small.

Most suited to efficient markets: 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.

Limited options: Today, there aren't enough passive funds for executing all types of investment strategies. The universe of passive funds available to Indian investors needs to grow. There is also lack of awareness among Indian investors about index funds.

The author is a free lance writer