Right from our childhood, we are taught to be creative—to work on something which is our own and not copied. Our family members and teachers constantly teach us ‘not’ to replicate someone else’s ideas but to focus on our own ideas as this will help us to succeed in life.
As we grow up, we realise that replicating someone else ideas cannot be considered as stealing always. Sometimes we follow up the footsteps of some of our colleagues at our work place so that we can work like them and gain success.
American author and motivational speaker Anthony Robbins, once said, “If you want to be successful, find someone who has achieved the results you want and copy what they do and you'll achieve the same results.”
This same concept in some way can help us understand what index funds are and how they work.
An index fund is a mutual fund scheme that invests in the securities of the target index—such as the BSE Sensex, Nifty or S&P 500—in the same proportion or weightage. There is no attempt to use traditional active money management on individual stocks or specific sectors in an attempt to outperform the index. Thus, indexing is a ‘passive’ investment approach emphasising broad diversification, low operating expenses and low portfolio trading activity.
Though index funds are designed to provide returns that closely track the benchmark index, these funds carry all the risks normally associated with the type of asset the fund holds. So, when the overall stock market falls, you can expect the price of shares in a stock index fund to fall, too. In short, an index fund does not reduce market risk—the chance that the overall market for bonds or stocks will decline. Indexing merely ensures that your returns will not get move away from the returns on the index that the fund mimics.
Some of the index funds include Principal Index Fund, UTI Nifty Index Fund, Franklin India Index Fund, SBI Magnum Index Fund, ICICI Prudential Index Fund and IDBI Nifty Junior Index Fund and IIFL Dividend Opportunities Index Fund among others.
Indexing is an investment approach that seeks to match the investment returns of a specified stock market benchmark or index. When indexing, an investment manager attempts to replicate the investment results of the target index by holding all—or in the case of very large indexes, a representative sample—of the securities in the index.
1. Lower expense ratio
2. Lower transaction costs
3. Greater diversification
4. Less prone to the risk of fund manager’s performance
Low expenses: Index fund is a less expensive form of investment than actively managed funds. Index funds do not require the services of high price portfolio managers, analytical work of security analysts, etc. Portfolio management of index funds is much less labour intensive than that of actively managed funds. The lack of active management generally gives the advantage of lower fees. The expense ratio for index funds is in the range of 1%-1.5%. There is no entry loads now on index funds.
Portfolio turnover: As the objective of an index fund is to mimic the index, a fund manager does not need to keep changing his portfolio like in the case of active fund management. He would need to change his portfolio only if there is a change in the index constituents. Thus, index fund is a low-cost concept. These savings made in costs, taken over a long period of time result in substantial gains for the investor.
Low risk through diversification: Market indices are constructed to represent performance of the stock market as a whole. The constituents of an index would represent the largest and most liquid companies from different sectors of the economy. By diversifying, the company specific risk is largely reduced.
Investors in index funds are committed to a low risk profile. Since the indexes have diversified portfolios and the stocks in the index fund are held in the same proportion as in the index, it is less prone to risk.
The job of an index fund manager is to track the index as closely as possible. They should make timely adjustments in the portfolio to match the index.
Tracking can be achieved by trying to hold all of the securities in the index, in the same proportions as the index. It is usually impossible to mirror the index as the models for replicating cannot be 100% accurate. The difference between the index performance and the fund performance is known as the tracking error.
An index fund manager needs to calculate his tracking error on a daily basis. Lower the tracking error, closer are the returns of the fund to that of the target Index.
By design, an index fund seeks to ‘match’ rather than outperform the target index. Therefore, a good index fund with low tracking error will not generally outperform the index, but rather produces a rate of return similar to the index minus fund costs.