Index fund aims to give returns in line with benchmark

By: |
May 29, 2015 12:05 AM

An index fund is a mutual fund with a portfolio constructed to match or track the components of a market index, such as the Nifty or the Sensex

An index fund is a type of mutual fund that has a portfolio constructed to match or track the components of a market index, such as the Nifty or the Sensex. An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. There are more than two dozen index funds available for investing, with the first index fund launched in 1999.

How it works

Index fund is a passive form of investing. It’s meant for those who do not want to track and invest in individual securities and wish to invest in a benchmark (reflecting the market movements). The portfolio construction in an index fund is similar to the one to which its benchmarked. So, if an index fund is benchmarked to the Nifty, the portfolio will constitute the same 50 stocks as the benchmark.

It is a passively managed fund where one has to buy and hold the stocks that form part of the index, and exactly in the same proportion. For example, if ITC has a 5% weight in the Nifty, a fund tracking the index will hold ITC in the same proportion.

The investment objective of such a fund is to achieve returns in line with the targeted benchmarked index. It carries the same risk associated with any other mutual fund investment. Since the mandate of the fund is to invest in securities of benchmark indices, the movement in the indices will be reflected in their NAV.

However, do the returns generated by an index fund mimic the Nifty or the Sensex? If the one-year return in the Nifty is, say, 15%, will the index fund benchmarked to the Nifty also deliver the same? The answer is ‘no’.

The difference in returns is on account of tracking error. The lower the tracking error, the closer the returns to the benchmark. The expense ratio, that is, the cost to operate the scheme of the mutual fund, is high. It’s not surprising to find expense ratios (in a regular plan) as high as 1.7%, the lowest being 0.3% and the median around 1% (in a direct plan, the expense ratio is lower by 0.3%).

The fund also has to set aside a certain percentage in cash. This is to ensure that in the event of redemption request from investors, there is sufficient liquidity.  In a rising market, the cash-in-hand and the expense ratio will typically make returns in index funds lower than the benchmark.

Performance

Over a 10-year period, the Sensex has delivered an annualised return of over 15%. So, for an investment of Rs 1 lakh in May 2005, the value of a fund, if invested in the Sensex, is Rs 4.10 lakh.

However, returns across various index funds tracking the Sensex and Nifty have ranged from 11. 6 % to 14.86%
At 11.6% , the return is Rs 3 lakh against the index return of over Rs 4 lakh. And at 14.86%, the return is closer to Rs 4 lakh. In three- and five-year time-frames, few index funds have delivered returns above the benchmarks.

Apart from tracking error, changes in index constituents and corporate action like declaration of dividend and bonus, also make the fund realign to the indices. Alternatively, actively managed large-cap funds, which typically invest in top-100 or top-200 companies, have out performed the Sensex and the Nifty.

Data of returns over the last two decades show that actively managed funds give higher returns than index funds. A wider range of constituent in index funds and lower expense ratio would make them more attractive to investors.

The writer is founder and managing partner of BellWether Advisors LLP

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