Monday, May 05, 2008


Index Funds

“..the best way to own common stocks is through an index fund…”-Warren Buffett, Berkshire Hathaway, Inc. 1996 Shareholder Letter.

In the history of 20th century personal finance, three developments will emerge as paramount: the recognition of the growth potential of common stocks, the explosion of mutual funds, and the advent of indexing.

To understand index funds, it makes sense to look at two different kinds of investment strategies for stocks - Active and Passive investing. The active strategy involves a lot of effort in doing research to pick good stocks and may involve significant costs when shares are bought and sold regularly. The passive strategy, also known as indexing, is much less complicated and involves tracking or mimicking the performance of an index like say the Sensex or the Nifty and building a portfolio with the same stocks in the same proportion as the index. The holdings of the fund mirror the stocks that make up the particular index. Investors in index funds are considered passive investors. They do not involve any research or active investment management - what they invest in is decided by the chosen index.

Moving with markets...getting rid of risk

When the index reaches dizzy heights, many investors often wonder as to why the NAVs of all the funds in their portfolio does not go up in the same manner. It is all about the portfolio composition of the scheme i.e. the quality of the portfolio as well as the level of exposure to different market segments that influences the level of fall and rise in the NAV. Since actively managed funds have varying degree of exposure outside index, the impact of its movement on the NAVs differs from fund to fund. No wonder, some funds that react slowly during the initial phase of the recovery in the market, often outperform others as the rally spreads to all the segments of the market. The moot question, therefore, is whether it is possible for investors to ensure that their portfolios move in line with the market. Index funds are, at times, projected as an answer to this need of certain section of investors.

An Index Fund is, thus, a mutual fund that seeks to replicate the returns generated by an Index. It is a passive style of managing portfolios as the fund manager invests the funds in the stocks comprising the index in similar ratio. This reduces the risk associated with that of the general market conditions. Index Funds provide a perfect investment avenue for investors looking to invest into equity but still not willing to take higher risks. In this case, the investor diversifies his risk due to other components prevailing in the market. An index fund is considered to be fully diversified as the component of unsystematic risk is minimised. The only risk that is left is the Market Risk, which cannot be diversified.

The modalities…

Index funds invest in a basket of predefined stocks of an index (like the BSE Sensex or S&P CNX Nifty) in an allocation that resembles that of the benchmark index and it is content at giving index-linked returns.

The divergence…

Active funds diverge from index funds on two important counts - volatility due to stock and sector risks and expenses due to constant churning.

The origin…

Index funds were first started in the US in the 1970s when the research that established the efficient markets concept began to trickle down to the finance industry.There are about a thousand index funds in the US like the Vanguard 500, which tracks the S&P 500 index. They made their debut in India in 2001 when Benchmark Mutual Fund made no bones about the fact that it was going to launch only index funds. Seven years ago, it had a tough time convincing distributors and investors of the opportunity in passively managed schemes. Today, Banking Index Benchmark Exchange Traded Scheme is the single largest equity-dedicated scheme being managed by any asset management company in India. Nearly two dozen funds have entered this space in the past seven years.

Steadily getting stronger…

Over the last three years, the gap of out-performance by actively managed funds over the indices is reducing. It does not mean that fund managers have run out of ideas, but there are some structural changes like better corporate disclosures and the increasing number of informed and professional investors in the market. Due to this, the ability to add value becomes less, which is why indexing is a much more sustainable strategy over the longer term. As is true elsewhere in the world, the more the markets mature and become efficient, the more difficult it becomes to outperform the index.

Not-So-Passive Returns

The major advantage of investing in an index fund is that one knows exactly the shares the fund would invest in. Besides, for an individual investor, it is practically impossible to create a portfolio that matches an index fund portfolio. Added to these is the relatively low cost of management as trading and research costs etc. is minimized. And above all, even small investors can afford them, as the minimum subscription amount is low. Index funds can give you wide exposure-at low costs.

The downside of investing in an index fund is that one forfeits the possibilities of earning above average returns that a good quality diversified fund may be able to provide over the longer term.

The capitalization of the index is not well spread across sectors in the Indian stock markets due to the inherent defect in the construction of the index itself. The basic principle here is: the more the number of stocks comprising an index the better is the diversification and price discovery.

Since index fund schemes mechanically track an index, instead of choosing shares that may or may not outperform it, they simply buy all the shares in a given index. Thus, the performance of an index scheme will always mirror that of the index, faring neither worse nor better than, on an average, the stockmarket. That's why they are equated with robots, with the fund-managers being described as black-box managers since they merely program a computer to buy shares in proportion to an index as it changes.

Robert Stambaug, a Wharton finance professor, says that while it is theoretically impossible for the average active fund to outperform the average index fund, discerning investors would look out for those fund managers who make the most of market imperfections. Some active funds can historically outperform the index, but if they do, the other active [fund] managers would have to under perform, because the average [return] would have to come out to be no better than the index [funds' average]. So a market where prices are essentially wrong would give the opportunity to the best active managers. But even in that kind of market, the average active manager cannot beat the index!

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