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Market linked returns at low cost make index funds attractive
Published On , 3 May 2016 By Times Of India
Very often investors are faced with the issue of wanting to invest in the stock market but are afraid of the risks associated with it. One of the ways to lower this risk of stock market exposure is to identify those stocks which have, historically, shown lower volatility compared to other stocks and invest in those stocks.
Another way to lower stock market risks is to invest through the Equity mutual fund route. In mutual funds, for a small fee, experienced fund managers and analysts, take care of investors’ money and try their best to optimize their profits after taking care of the risks associated with such investments. Within the mutual fund space also there is a category of funds, called the index funds, which offer even lower risks of investing in the stock market and also at a relatively lower cost.
Index funds are those mutual fund schemes in which the fund managers build their portfolios which replicate the constituent of an index which is called the benchmark index for that fund. For example, if an index fund replicates Index A in which Stock A has 10% weightage and Stock B 9%, and so on, with 30 stocks in total, the fund manager for the index will also have Stocks A and B and the rest 28 stocks in his/her portfolio with exactly the same representation. So in the market, the day the Index A rises 1%, the index fund portfolio will also rise 1%. The day the index falls 1%, the index fund portfolio will also fall 1%. There could be some very minor deviations from this rise and fall in the index, which is called tracking error.
This is called passive index fund investing compared to regular Equity fund investing where the fund manager tries to buy and sell stocks in the portfolio in order to maximize returns.
Because of the passive nature of investing, compared to active fund management, costs for these funds are also low. “Index funds tend to be more costeffective than actively-managed funds and can be a transparent option as the investment is intended to mimic the underlying index,” said Koel Ghosh, head - business development, South Asia, S&P Dow Jones Indices. “As the index is often constructed by an independent index provider, the rules and the construction are typically published and made available for investors to access. This transparency is intended to helps investors understand the investment strategy,” Ghosh said.
There are specialized agencies around the globe which launches and maintains specialised low-volatility indices which could be used as benchmark index for some index funds. According to a note from S&P Dow Jones Indices, an index which represents low volatility stocks and “rebalances quarterly to reflect the least volatile 20% basket (of stocks), weighted in terms of their volatility has been seen to have generally outperformed traditional market cap indices, because of the downside protection provided in adverse market conditions”. On the question of how much of an investor’s portfolio should be invested in index funds, Ghosh said that an investor’s investment allocation is usually based on the individual’s risk-return profile. “Many investment strategies employ a core satellite strategy wherein either an active strategy or a passive strategy can constitute one’s core strategy and the other satellite. This approach is intended to allow an application on both active and passive styles to achieve investment Goals,” Ghosh said.
According to a top official at a large domestic fund house, it depends on what exactly the investor is looking for from an index fund. “If the investor is happy with a return that is equal to the index return, he/she can put all his/her Equity portfolio into index funds,” said the official.
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