Index Funds - Who cares for slumps ?

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Any investor worth his salt is to be familiar with names like BSE 30, BSE 100, Nifty etc. no these are not names of CYT’s (Cute Young Things), rather these are lists comprising of the stalwarts in the stock market. The old, the new, the young, the not so young-all the movers and shakers of the Indian stock exchange are on the list. These indices represent the market heavy weights in terms of market capitalization which also turn out to be the most heavily and frequently traded popular scrips. Different indices have different criteria of formation. some include the top 30 scrips in terms of market cap, some include the top 100, you can even have sector dedicated indices like the mindex(software), lifex(pharma), brandex(FMCG) etc.

Even though you as an investor would like to invest in these market heavyweights, the prices may be prohibitive. With the demat, the concept of market lot has finished, so one does not need to pick up 10, 50 or 100 of each scrip to make it a tradable lot, you can buy and trade in even one share of a company, but then the holding is hardly worth its while. Also the equity markets have their cycles-the ups and downs –you as an investor would like to have a cushion against these fluctuations. If you have invested in one scrip alone, your exposure is too naked and direct, however if you have invested in a basket of scrips then you can even out the movements and reduce the fluctuations. And this especially is the case with index scrips which are normally traded pretty heavily and are also volatile. So where does all this leave the small investor wanting to benefit from investment in the market heavyweights?

This is precisely where Index funds come in.

Indexing is a simple strategy designed to track market returns. Indexing, or investing in the entire stock market, is one of the easiest, least risky, and yet most effective investment strategies available. Index Mutual Funds are designed to try to match the performance of the stock market, or a specific sector of the market, as measured by the appropriate benchmark index. They basically guarantee that the fund's performance will match an index. This strategy has consistently beaten 70 percent or so of all growth funds over the years. For example the S&P CNX Nifty appreciated by 5.8% in past week, to close at 1,240 points (6th Nov 2000). Major stocks like Infosys, Zee Telefilms, Satyam Computers and MTNL logged in substantial gains, which resulted in this upturn in market performance.

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Following this trend Index funds, which have an investment objective of investing in companies whose securities are included in the S&P CNX Nifty Index (or some other benchmark index) like UTI-Master Index, Franklin India Index Fund, IDBI-Principal Index Fund, UTI Nifty Index, have consequently shown a good performance over the period under consideration. If the market uptrend continues then there is a good chance that these funds will turn the corner and give positive yearly return.

In The Wall Street Journal, Burton G. Malkiel, author of A Random Walk Down Wall Street, reflected on why index funds get higher returns than most actively managed funds:"Why does indexing outmaneuver the best minds on Wall Street? Paradoxically, it is because the best and brightest in the financial community have made the stock market very efficient. When information arises about individual stocks or the market as a whole, it gets reflected in stock prices without delay, making one stock as reasonably priced as another. Active managers who frequently shift from security to security actually detract from performance by incurring transaction costs."

An index fund invests in all the stocks on which a market index is based. For example, an index fund based on the BSE 100 invests in all of the BSE 100 companies. As a result, the performance of index funds tends to mirror the performance of the index. So just as stocks are often used as the basis for mutual funds, stock indexes are used as the basis for an instrument called an index fund. Beginning investors are attracted to index funds because the returns are relatively dependable, relying solely on the index performance and not the decisions of a portfolio manager.

Investors, especially the small ones, benefit in many ways through investment in index funds. Firstly an index fund is a passively managed mutual fund that tries to mirror the performance of a specific index. Since the index funds are attempting to mirror the index funds, decisions are automatic and transactions are often infrequent. This also does not require the management of a professional money manager, and therefore expenses tend to be lower than those of actively managed funds. This leads to the benefit of Lower Costs. Most stock funds that are actively managed by professionals, charge annual fees of 1 percent or more, with some charging over 2 percent per year. These fees are meant to cover the costs of commissions and research. Non-index funds often trade the stocks in their portfolios on a frequent basis, which also causes lots of tax consequences -- when you trade frequently in any portfolio, you incur capital gains. In a mutual fund, these gains must be distributed to shareholders on a regular basis (which means you must pay the tax man). Index funds don't trade often at all, which means there is less tax liability for your portfolio. Index funds also represent Lower Risk. Of course, there's nowhere to hide in a major market downturn or crash, but indexing can help you avoid being in the wrong sector of the market. You won't be among the top performing funds if you index, but you won't be at the bottom either. And you won't be caught investing in the "hottest" sector of the market, only to see your fund drop 20 percent as another type of fund assumes leadership. Index funds also ensure that you always stay invested. This is my personal favorite. Nothing makes me madder than a fund which misses out on a big market rally. Index funds don't have to worry about poor market timing and don't have to worry about missing the turnaround sectors. In the long run they also ensure that you get Guaranteed Market Returns. Since the general trend of the stock market remains upward, you want to make sure that your investments are constantly gaining ground. By indexing all, or at least a "core" of your portfolio, you'll make sure that the market doesn't leave you behind over the long haul.

They are also fairly easy to understand. The investor doesn't have to worry about fund style, management ability, etc. Offer you Instant diversification, i.e. An index fund provides broad diversification by featuring hundreds of stocks drawn from different industries or sectors, thereby helping to limit the negative impact of a downturn in any single stock or sector. On an average they offer better performance. Only 10-20% of mutual fund managers outperform the overall market, so an index fund that's able to approximately match the performance of the overall market will beat 80-90% of all mutual fund managers. Your money is fully invested, unlike a portfolio of stocks, which often has some cash position. Index funds are often more tax-efficient than other equity funds.

Of course, even if you're convinced that indexing is indeed a valid strategy, there remains the question of which index or indexes to follow. While by far the most famous is the BSE 30 stock index (the 30 largest companies in India), there are both broader and more concentrated, as well as sector dedicated bond, and other index funds. However on the whole any lower-cost, broadly diversified fund will be good enough . Unless its investment strategy is dramatically different than most funds, its performance will approximate the index. The more stocks or bonds it owns, by definition, the closer its performance will be to an index.

Remember, the main thing is to stay invested. As an indexer, you'll be in good company, too. Pension funds, insurance companies and other big institutional investors have used indexing strategies for years. If you have the time and patience to weather the market's inevitable down cycles, index funds offer a simple way to share in the stock market's long-term growth potential. Index funds can function as either a core portfolio holding or as a complement to more-specialized investments in your portfolio.

Aru Srivastava

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