Index based investing – a Primer

  

Index based investing is gaining popularity in India.  Mutual Funds have a wide range of Index Mutual Funds and ETFs giving investors the opportunity to ‘invest in an Index’. The concept is explained below.

What do you mean by Index Mutual Fund schemes and ETFs? How can I invest in these?

An Index is a selection of stocks which is representative of the market and captures the ‘mood’ of the market or a certain section of the market. A bellwether index is one that represents all sectors of the market. Examples of such indices are the NIFTY and Sensex. There can be indices for certain specific sectors and segments of the market like midcap stocks, Banking, IT and Automobile sectors which are selection of stocks representative of that particular sector.

Traditional Index Mutual Fund Schemes

These are regular mutual fund schemes which invest only in the securities that are part of an index e.g. the NIFTY or Sensex and are intended to track the returns of a particular index. The fund manager invests only in the stocks that comprise the index. Unlike actively managed equity funds, index funds do not attempt to outperform the benchmark index. The returns of such funds mirror the returns of the index that is tracked.

As an investor, you can submit application forms, transaction slips at the Service Centre of the Registrar/AMC just as you would do to purchase units of any other scheme. You may also invest online.

The purchase price / redemption price would be NAV based and the rules regarding applicability of NAV apply.

Thus, investors who wish to track the returns of an index could subscribe to such schemes. 

Then what are ETFs?

Exchange Traded Funds are essentially index funds that are listed and traded on exchanges like stocks. The fund manager of the ETF also invests in the basket of stocks that make up the index.

These Mutual Fund units are converted into share-like securities and traded on the exchange.  The units can be bought and sold like shares on the stock exchange at any time during trading hours. Purchases and sales are not through a Registrar, but on stock exchanges.

A point to note is that even though the ETF’s trading value is based on the net asset value of the underlying stocks that it represents, i.e. the stocks which make up the index, but the trading value may not be the NAV. It is a Mutual Fund that investors buy and sell in real-time at prices that change throughout the day.

Thus ETFs are share-like securities, traded on the exchanges which also mirror an index and offer investors the convenience of buying into an index.

The differences:

• Demat Account: This is required to buy or sell ETFs. Demat accounts are not required to purchase index mutual funds.

• Transactions: ETFs may be purchased like shares through a trading member i.e. broker of the exchange. For traditional funds, the purchase may be made through the Registrar/AMC.

• Redemption of Index Funds can be done in the same way as you would redeem any other Fund you hold. In the case of ETF, liquidity is possible by selling the ETFs on a stock exchange.

• Price: In the case of ETF, the price of purchase or sale will be close to the NAV but not necessarily the NAV and may change throughout the day. The price for traditional index mutual fund schemes is fixed at the applicable NAV. Load if any is applicable.

• Minimum Purchase Amount: Can be one share for ETF. For a Mutual Fund it is specified in the KIM, often Rs. 5000.

Points to Note:

1. Tracking Error

Since these Funds are supposed to faithfully follow an Index, the performance is measured by noting the tracking error. This refers to the difference between the performance of the Fund and the index that it tracks.

The reasons can be many including the necessity of keeping a cash balance ready for redemptions and I will deal with this in another post. However, financial websites publish the tracking error and one must note this when investing.

2. Liquidity

If you have invested in an ETF, you may find it difficult to sell the shares in the exchange if the ETF is not widely held and has a small AUM. Please be careful in buying ETFs and go only for large ETFs. In this matter, Index Funds are more liquid since the Fund has to redeem at NAV! Selling an illiquid ETF could mean that you get a much lower price than NAV.