A portfolio of securities, the ``index fund'' is specifically designed to represent the characteristics and attributes of a chosen target index. It has the same exposure to significant characteristics such as company size, sector representation, foreign-earnings etc, as the index. Hence, the rate of return on the portfolio is very close to the rate of return on the index. In other words, indexing is a structured portfolio strategy where the bench mark is to achieve the performance of the predetermined index. Thus, an index fund consistently gives the same return as the index and theoretically with zero risk.

Indexation differs from the traditional ``Buy and Hold'' strategy because it involves the frequent recaliberation of the holdings in order to track the changing risk and return characteristics of the market. Indexing is the passive strategy involving minimal expectational input.

Index fund managers abandon the attempt to beat the market through active ``security selection'' or ``market timing'' and instead seek optimal diversification by indexing their investment to the market portfolio. This practice is based on the theory of efficient market which holds that in medium to long term, no international manager can hope to obtain exceptionally good and sustained performance in efficient markets. In other words, an attempt to beat the market is futile. However, if one ponders, one will find that all stock markets are not mature i.e. perfectly efficient and that's fair enough a reason why the theory may not hold good at all times. This, by itself, throws open the opportunity to make the best out of the imperfections in the market and expect higher returns than the index which represents the market as a whole.

However, empirical studies comparing the returns from schemes as calculated on the bases of NAV, market price and repurchase price against the various market indices, namely the BSE Sensex and BSE National Index, reveals that most of the mutual funds in India have not been able to outperform the sensex and fund managers have failed to exhibit market timing ability.

Over the past five years, almost all growth funds, which have provided highest possible returns to the investor, have performed worse than the Sensex. This is one of the arguments in support of indexation. Index funds are designed to meet certain specific requirements of the investor. The rate of return achieved by the fund closely represents that of a given index.Another reason for better performance by index fund is that market index is able to avoid excess risk and obtain consistent returns since it represents a diversification across a fairly wide range of instruments. The strategic argument maintains that in addition to consistent performance, index funds offer efficient use of investment resources.

Indexation lessens investment cost in three important ways. First, it minimises brokerage commission and market impact cost by minimising the necessity to transact. Second, when transactions occur, their market impact is minimised because index portfolios are generally invested in securities in proportion to their market rates and the largest investments tend to be in securities with high liquidity. Third, because indexing dispenses with costly asset selection and marketing timing research, managing fees can be significantly lower than those associated with active strategies. Thus, indexation in the long run not only exhibits a better performance but also proves to be a less expensive investment management technique than active management.

Indexation is economically desirable as it is efficient for maximising returns to investors and in a fund (such as a pension fund) where many contributors are involved, it minimises contributions for a particular level of eventual return. Index funds do enjoy the power of rock-bottom expense but they are certainly not costless. They involve management costs to be deducted from the NAVs periodically, opportunity cost of cash holdings and cost of borrowing because of changing size of the fund and the cost of investment and disinvestment. It is here that the role of the fund manager is crucial. He has to use his intellect in earning enough to offset the costs and give the investors a market rate of return. Globally, managers use index futures as hedging and liquidity matching tool. However, Indian fund managers are handicapped for now since futures trading is not allowed in India as yet.

The concept of index funds is new to India. It has caught attention ever since the launch of the ICICI Index bonds which is based on a similar concept. The ICICI came up with its index bonds last month which was constituted as a discount bond with a detachable index warrant. An investment of Rs 6000 now promises Rs 22000 after twelve years and an additional detachable warrant for an amount calculated as under:

Amount to be received = Rs2000 x BSE Sensex at year 2009

BSE Sensex at year 1997

So, the return to the investor on the index bond would work out to a minimum annualised yield to maturity (YTM) of 11.44 per cent along with an amount on the warrant. Under all circumstances, the investor is assured of a minimum return.

The present offer by UTI for index equity funds also provides a safety net. The original investors are given the option to repurchase at par up to 500 units after one year, for a period of one month, should the NAV go below par value of Rs 10. Thus, the investor need not worry about the slide in NAV since the principle is intact. Therefore, one can take a chance without losing much.

In fact, for an average investor, an index fund could turn out to be a boon. For one, it eliminates the risk relating to the choice of shares by the investor and the management charges are much lower than that for the managed growth funds. And, of course, this is in addition to the fact that on an average, index funds do better than managed growth funds. However, index fund is appropriate only if you are satisfied with an average rate of return. But if you are expecting above average or extraordinary returns-it is highly unlikely-so forget it. Otherwise you will be in for a big disappointment.

--Value Research

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.