What are Index Funds?
An index fund refers to a mutual fund type with a portfolio structured according to the constituents of a market index like the Sensex or the Nifty. This kind of mutual fund is said to have low operating costs, extensive market exposure, and decreased portfolio turnover. Index funds stick to certain standards or rules which stay permanent irrespective of varied market states.
Index funds buy stocks in similar proportion as in a specific index. The performance of the scheme thus corresponds to the index that the fund is tracking. Index funds are not designed to beat the market, but to mimic the Index’s performance.
It may be noted that index funds do not always match its index returns and some scheme returns may not be similar to the performance of the index that it tracks. This is referred to as tracking error and it measures the amount of deviation of an index fund yields from the benchmark returns that it tracks. Those who want to invest in index funds must check the tracking error figure. A low tracking error means that the scheme’s performance is better.
Investment in index funds can be considered as a type of passive investing. The main benefit of such investments is reduced management expense ratio associated with an index fund. The managers who manage index funds just replicate a benchmark index’s performance and hence do not require the services of experts or analysts who help select the stocks that make up the portfolio of mutual funds.
On the other hand, research is required for actively managed funds. In such instances, the additional expenses of managing the fund are reflected in the expense ratio, which are subsequently borne by the shareholders. As expense ratios get directly reflected on funds’ performance, actively managed mutual funds with their high expense ratio are comparatively at a disadvantage with regards to index funds.
Investing in Index funds in India
Investors have 3 options with regards to index fund investments in India. You can invest in an index fund that tracks the Nifty, or one which tracks the Sensex, or thirdly in an index plus fund. The Sensex has 30 companies in its index while the Nifty has 50 companies. Most of the assets of index plus fund are invested into a specific index while the remainder of assets gets actively managed.
Index funds come highly recommended by all, including greats like Warren Buffet. It may however be noted that Index funds have shown great performance only in the United States and other developed markets where it is nearly impossible to beat the benchmark. India, on the other hand, is an emerging market and several Indian companies have the potential to grow at a rapid pace and provide returns that outdo the index performance. It is believed that this trend may continue for a minimum of 5 more years.
Investors in India can continue to invest in actively managed funds, or they may take a chance and park a percentage of their savings in Index funds.
What are Exchange Traded Funds?
Exchange Traded Funds or ETFs are a type of mutual funds which are rapidly increasing in popularity with investors. These funds collect investments and use strategies that are similar to normal mutual funds. They are however structured as investment trusts with the capacity to be purchased, traded, and sold on varied stock exchanges. ETFs also feature the additional benefit of having some the same features as stocks.
ETFs can be bought or sold over the stock exchange at any period during a business day, from the time the opening bell rings till the time the market closes. These funds can be sold short or purchased on margin. The fees associated with ETFs are also lower as compared to other mutual funds with similar portfolio. There are many types of exchange traded funds that provide active options varied market benefits to investors where they can hedge or leverage their spots. ETFs come with different tax benefits, are versatile and convenient, and hence are very popular with investors.
ETFs vs. Index Funds
ETF’s are flexible options of investment and appeal to a wide section of investors. Both active and passive investors and traders find the characteristics of ETFs very appealing.
Since ETFs can be easily traded as stocks, active investors/traders are attracted to the convenience offered by these funds. This option allows them the trading flexibility and the margin that cannot be matched by index funds. Also, unlike regular stocks, exchange traded funds are exempt from the rule of short sale uptick.
The flexible aspect of ETFs is loved by passive institutional investors, many of whom consider it to be a great and reliable substitute to futures. Some of the flexibility aspects of ETFs include the following:
- ETFs no not need special accounts, specific documentation, margin, or rollover expenses.
- They can be bought in small sizes
- Some ETF portfolios cover benchmarks which have no futures contracts.
Index fund are really simple to handle and hence are very attractive to passive retail investors. Index funds do not require a deposit or a brokerage account. The investor can simply buy index funds using their banks.
- The Costs
Both index funds and ETFs have some disadvantages and benefits with regards to cost management of the associated assets. The fee difference may sometimes be favorable for one as compared to the other. Investments in ETFs come with payment of brokerage commissions, while investors can purchase no-load index funds with no transaction expenses.
ETF or index fund portfolio needs to be rebalanced by an investor, via purchase of certain positions and sale of others. A portfolio with ETFs acquires commissions via sale or purchase of the ETFs. Since trading is usually done in broad lots by an investor, it is nearly impossible to get the precise weightages of each desired ETF. This is particularly so in case of small portfolios. Investors in index funds can get precise asset allocation weightages as they can buy fractional units. Also, there are no transaction expenses in no-load index funds.
With ETFs, the interest received or the dividends accumulated from the associated securities have to be passed onto the shareholders at the end of each quarter. As opposed to this the interest income or dividends accrued by index funds are immediately invested.
Certain ETFs may not be that liquid, which can cause the bid-ask spread to increase, thereby leading to additional costs in trading the funds. Also, ETFs which are not that popular come with the risk of similar arbitrage interest as compared to other ETFs, thereby triggering a potentially bigger difference between their NAV or net asset value and market prices. The NAV of Index funds can always be found by investors at the end of a business day.