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N Mahalakshmi
At last, we have an index fund. The Unit Trust of India launched the first domestic index fund called Master Index Fund in June, 1998. The fund opened for fresh sale and repurchase on October 1, 1998. Is it the safest bet for equity investors ? Before deciding, let us ponder over the thematics of index investing.
Index Funds are essentially those which try to replicate the market index. An index fund is formulated in such a fashion that it carries the same stocks as in the index and in the same proportion. The fund represents the characteristics and attributes of the chosen target index and hence, the rate of return on the portfolio is very close to the the rate of return on the index. In other words, indexing is a structured portfolio strategy where the benchmark 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.
Index funds are passively managed and broadly follow a "buy and hold" strategy. Indexfund managers donot churn their portfolios often as the relative proportion of the index constituents do not change very frequently. However, alteration are made in the portfolio to match the composition of the index.
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. The practice is based on the theory of efficient market which holds that in medium to long term, no fund 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 thinks a bit harder, 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 indexwhich is the best possible representation of the market.
Interestingly, even in an inefficient market such as ours, fund managers have seldom outperformed the market over a longer time span. A quick look at the performance table will at once suggest that over a period of time, returns regress around the mean and returns from actively managed funds at best match market returns. Although over a narrow time frame, quite a number of equity funds have been able to outperform the major market indices, not even a handful have been able to beat the index over a five year time span.Clearly, over a longer tenure, fund managers have failed to exhibit market timing ability. In fact, in the past five years, almost all growth funds, which have provided highest possible returns to the investor, have performed worse than the Sensex.
Less Risky
One of the reasons for better performance of the index fund is that market index is able to avoid excess risk and obtain consistent returns since it represents adiversification across a fairly wide range of instruments. The fund obviously is not riskier than the index, though it carries a market risk.
Cost Effective
Index investing 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 minimsed 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, since 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.
Index fund do enjoy the power of rock-bottom expenses but they are certainly not without cost. Theyinvolve management cost 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.Launched in June 1998, Master Index Fund is a passively managed index fund replicating the BSE-30 sensitive index. The funds mobilised under the scheme will be invested in the equity shares of companies comprising the BSE 30 sensex in the same proportion as that of the BSE 30 sensex so as to track the index, with minimum tracking error. There shall be no income distribution under the plan.
The minimum investment under Master Index fund is Rs 5000. Aninvestor can enter the scheme upto 12:00 PM on a particular day at the previous day's NAV and UTI will deploy the money in sensex scrips on the very same day. The Sensex's position at the end of the day in which he entered will be the benchmark for deciding whether he has gained or lost. For example, if an investor enters on Tuesday at Monday's closing of 3000 points and the Sensex closes on Tuesday at 3,200, leading to a rise in the NAV of the scheme, then the benefit reflected in the NAV of the scheme would be his gain for the day. If the index falls, then it will translate into a loss.
The fund is sold at NAV but the repurchase is at a discount of around 3 per cent to the NAV. A 3 per cent exit load would suggest that the sensex will have to appreciate over 3 per cent to provide a positive return to the investor.
Considering a Sensex level of 3000, the index will have to gain 90 points for the investor to break-even. In the three and a half months since launch, the Master Index Fund has outperformedthe BSE Sensex. The fund has fallen by 10.1 per cent while the index has plunged by 11.56 per cent. But that's nothing to rejoice. An index fund cannot theoretically outperform the index which it attempts to replicate. Any marginal outperformance has to be a tracking error.
At times the fund may not be able to exactly replicate the proportion of the index constituents and if the fund happens to be slightly overweight on scrips that appreciate more than the average, the fund will manage to outperform the index marginally. But be forewarned since it could only be a matter of chance.
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. 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 investors and the managed growth funds.
And, of course, this is in addition to the fact that on an average, index fundsdo 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 © 1998 Indian Express Newspapers (Bombay) Ltd.
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