By Shaily Gang
In an index fund portfolio, the index applies two to three rules to a pre-defined universe for stock selection and weight allocation. In an active portfolio, the basis of fund manager’s decisions is the ground-up criteria. It may be different for different stocks. Just like an investor would want to diversify amongst two funds —basically judgement of two fund managers, it could be a good idea to diversify amongst active investing and passive investing approaches.
The rules of index construction under passive investing do three things. They make things simpler as they reduce decision making time. They provide room for consistency and discipline as they take away ‘judgement’ from the decision making process. They offer lower expense ratios. So, investors, especially the young and new, should consider diversifying into the discipline of passive investing, too.
Indices evolve
As index funds replicate indices, the key is to understand what is getting replicated or which index is being tracked. These funds have a large spectrum – they can be broad market indices for market returns or thematic, sector or factor indices for higher risk. In fact, thematic or factor-based funds have higher return profiles as compared to broad market returns.
Indices do not remain static. For instance, in broad market indices of Sensex and Nifty 50, sectors which are heavily weighted today in the index like banks, finance, information technology were not featured in the benchmark in 1980. Regular little changes in the index over a long time help to keep chasing and capturing the evolving economy or the sector in its entirety.
Rules define strength of the index
It is important to understand which part of the market has been chosen to apply the rules — sector, theme or factor. The way rules are defined can make the index represent the market and make it diversified across sub-segments.
Strength of the index tends to increase by inclusion eligibility criteria and stock selection criteria. Inclusion eligibility criteria is largely related to Futures & Options (F&O) presence, trading frequency, average daily turnover and average daily full market cap. On the other hand, selection criteria is related to average free float market capitalisation.
The ineligibility of non-F&O stocks hitting the circuit filter more than a particular threshold level is another prerequisite of stock inclusion. Strength of the index is defined by what rules are applied, potentially leading to outperformance of the factor or sector over and above broad market indices.
Positioning index funds in overall portfolio
A novice investor can start with index funds replicating broad market indices and capture market returns rather than staying away from equities completely. An evolved investor can assess and take exposure to multiple high-risk high-reward index funds tracking themes, sectors or factors indices.
The writer is head, Products, Tata Asset Management.
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