Template investing: Good in a downturn

Many index funds charge less than equity-diversified funds. Select a fund that has a low tracking error.

With the Bombay Stock Exchange Sensitive Index, or Sensex, rising over 86 per cent in the last one year, investors seem to be again buoyant about stocks as an asset class.

While a lot of actively-managed funds have outperformed the Sensex, investors looking for cheaper options can look at index funds. Experts said while there were no guidelines from the Securities and Exchange Board of India (Sebi), many fund houses charged less fees than diversified equity funds.
 

TRACK RECORD
Scheme	*3-mth	*6-mth	*1-yr
Franklin India Index BSE Sensex	7.87	16.23	85.24
UTI Master Index	7.93	16.11	85.08
Tata Index Sensex A	7.80	15.80	83.99
Quantum Index	7.80	13.23	82.75
ICICI Prudential Index Retail	7.55	12.73	82.44
Franklin India Index NSE Nifty	7.78	13.22	82.43
Birla Sun Life Index	7.66	13.05	82.30
Magnum Index	7.66	12.98	81.87
Tata Index Nifty A	8.34	13.08	81.24
UTI Nifty Index	7.64	12.87	80.78
As on Nov 30, 2009; *: returns in %          Source: Value Research

Most fund houses charge 1-1.5 per cent as annual fund management fees whereas the cost is 2.25 per cent for diversified equity funds.

“As and when an investor wants more security on the equity side, he/she should increase the allocation for index funds in the portfolio,” said Mukesh Dedhia, director, Ghalla Bhansali Stock Brokers.

The returns, however, are not bad. Index funds have returned between 72 per cent and 85 per cent in the last one year. A typical index fund invests in stocks comprising the index and in the same proportion as in the index. Their returns should ideally mirror the performance of the underlying index.For example, the fund manager will passively invest in Nifty-50 stocks in proportion to their market capitalisation. Due to this, index funds are known as passively-managed funds.

There can be funds based on other indices which have a large number of stocks, such as the CNX Midcap 100. Here, the investment is spread across a large number of stocks.

Financial experts said ideally an investor could have 20-25 per cent of his portfolio in index funds.

While selecting an index, one should look at the ‘tracking error’ — the difference between the returns of the underlying index and the scheme. Internationally, the tracking error is less than 2 per cent (on either side), but it is much more here. Many schemes have returned less than 5 per cent, some even 10 per cent, lower returns than the underlying indices in the last one year.

The Nifty has returned 82.67 per cent in the last one year whereas HDFC Index Nifty and LIC Mutual Fund Nifty have returned 76.77 per cent and 72.43 per cent, respectively. “The tracking error is high sometimes because many of these schemes are actively managed. Some schemes invest in the same stocks as the index but with different weights, leading to tracking errors,” said an industry player.

These funds come quite handy in situations where investors wants to put in money but do not want to incur high costs. “One can look at index funds, especially when market conditions are bad and the annual fees charged by the fund house eats more into the already-falling returns,” said a financial planner.