Spend, Save and Invest Smartly
One knows that a risk averse investor plays safe while making his investments. Taking risks is not his cup of tea. Equity diversified mutual funds and shares are a strict no no. The statutory warning on mutual funds “mutual fund investments are subject to market risk, please read the offer document carefully before investing” is a turn off. There are several questions a risk averse investor would ask which causes him to hesitate picking up an equity diversified mutual fund commonly called an actively managed fund. The minimum term period one is advised to stick to equities in order to make a profit is three years. Fund managers are known to have an average shelf life of one to two years. Even if a fund manager is very good and has actively managed the portfolio well he might exit the Company at a crucial juncture for a better offer. The what if factor pertaining to the fund manager is a valid reason if one is a risk averse investor to think twice before leaping into the World of equities. But should a risk averse investor look towards an index fund which is passively managed and doesn’t carry these risks?
An index fund is basically an equity fund that mirrors or replicates a particular stock market index such as the CNX Nifty also called Nifty 50 or the S&P BSE Sensex. An index fund which tracks the S&P BSE Sensex will invest only in the thirty stocks which this index comprises of. The proportions of investment in each stock will exactly match with the weight of the stock in the index. All the fund manager has to do is to follow and replicate the index he tracks and invest in all the constituent shares in the same proportion or ratio as the index. Since there is not much a fund manager needs to do these funds are called passively managed funds. Since an index fund tracks a particular index and merely replicates its performance it can never outperform this index. One needs to keep an eye on what is known as the expense ratio in an index mutual fund. An index fund by virtue of being a passive fund incurs very low fund management fees. Since they replicate a particular index and buy and sell stocks based on its movements the transaction costs tend to be lower than an actively managed fund. In India the expenses of index funds are in the range of 0.5% and capped at 1.5% of the corpus or funds managed. Another important factor in an index mutual fund is the tracking error. One has the standard deviation which is a measure of volatility of the mutual fund. The difference between the standard deviation of the benchmark index and the fund is called the tracking error. Ideally there should not be a tracking error of more than 5% if the fund wants to be known as a good index fund. One must always choose a fund with a low tracking error and a low expense ratio as a high expense ratio means greater are the chances of a higher tracking error.
One needs to compare the performance of an index mutual fund against the index it traces over a period of time. There are two methods to measure the performance of an index mutual fund mainly vis a vis the market indices it tracks and the category average. One knows that the returns of an index mutual fund must be in line with the index it traces. An allowance is made for the tracking error which must be within the range of 5%.In certain cases there is a shortfall in returns of more than 10% between the index mutual fund and the index it traces. The benchmark index might give a return of 50% in a couple of years while the index fund might give a return of only 40% resulting in a shortfall in returns as high as 10%.This is an indication that something is severely wrong in the management of the fund. There have been cases in which index funds have over performed the indices they track. While one might consider this as a good indication the reason this could have happened is that the fund was actively managed instead of passively following the index it traces in line with its stated commitment. One needs to note that both underperformance and over performance of the index fund vis a vis the index it traces is an indication of bad performance by the index fund. Under category average one compares the performance of the index fund versus other index funds with similar objectives.
|Name of the index used as a benchmark||Funds which trace this benchmark|
|BSE FMCG Index||FMCG Funds|
|BSE IT Index||IT Funds|
|BSE Healthcare Index||Pharma Funds|
|S&P CNX Nifty and BSE Sensex||Balanced , diversified and tax planning schemes|
|Balance EX||Balanced Funds|
|MIPEX||Monthly Income Plan schemes|
If an index scheme of a mutual fund is sold at a profit the gains are known as capital gains. This is basically the difference between the purchasing price of the index scheme and the selling price of the index scheme which may be a positive value resulting in a gain. If the index fund is held for a period less than 12 months the gains are taxed as a short term capital gain. These short term capital gains are taxed at the rate of 15%.If the index funds are sold after a period of 12 months then the gains are called long term capital gains. These long term capital gains are exempt from taxes. This serves as an incentive for one to hold these index funds for a longer period of time and profit from capital gains.