If you are a laggard in direct equity investing even though you want to invest in equity, this is the best idea for you. Invest through Index funds. Direct equity investment required lots of time and research to find out good candidate to buy there stocks. In present days, most of the people doesn’t have enough knowledge to invest in equity but they are investing equity by hearing the tips from others or depends on any news’s. At last, this action will lead them to heavy lose of their capital. If you are direct equity investment laggard, investing through index fund is the best option for you.
Before starting to search and investing through Index funds, you should have the minimum knowledge about what is index fund and how it is working. An index An index fund is essentially a mutual fund that invests in the securities of the target index in the same proportion or weightage. Index funds are generally targeted to popular indices like BSE Sensex or Nifty, though index funds benchmarked to sector specific indices are also in vogue.
Index funds are designed to provide returns that closely track the benchmark index. They also carry all the risks associated with the class of securities invested in. So, when the overall market falls, the securities comprising the index fund too fall and so would returns from index funds.
Index funds do not eliminate market risk. They merely ensure that returns will not stray far from returns on the indices that the fund mimics. Index funds can be either for equity or debt.
The underlying assumption of indexed management is that financial markets are efficient over the long term, making it virtually impossible for active managers to consistently outperform the market. That’s why indexing has become popular with investors who prefer steady returns through a conservative, long-term, low-risk investment strategy.
How do you mirror the index?
“Indexing” is an investment approach that seeks to match the investment returns of a specified stock market benchmark, or index. When indexing, an investment manager attempts to replicate the investment results of the target index by holding all — or in the case of very large indexes, a representative sample — of the securities in the index.
There is no attempt to use traditional “active” money management or to make “bets” on individual stocks or narrow industry sectors in an attempt to outpace the index. Thus, indexing is a ‘passive’ investment approach emphasizing broad diversification and low portfolio trading activity.
What is tracking error?
Index funds are generally evaluated on the basis of the tracking error. This is defined as the annualized standard deviation of the difference in returns between the index fund and its target index. In simple terms, it is the difference between returns from the index fund to that of the index.
An index fund manager needs to calculate his tracking error on a daily basis especially if it is open-ended fund.
The lower the tracking error, closer are the returns of the fund to that of the target index. The tracking error is always calculated against the total returns index that shows the returns on the index portfolio, inclusive of dividend.
Tracking error indicates how closely the fund is tracking the index. It refers to the ratio of how close the weightages of the stocks in the portfolio are to the weightages of the stocks in the index. The more closely the weightage of the stocks are tracked in the index, lower will be the tracking error. The factors that affect tracking error are inflows or outflows in the fund, corporate actions, change of index constituents and the level of cash maintained in the fund for liquidity.
It also includes the cost that routinely subtract from fund returns. Expenses like transaction costs including broker’ commission, bid and ask spread, etc. gets subtracted from the returns of the fund.
The higher the expenses incurred, greater will be the tracking error.
Because of the tracking error, the returns from the index funds are usually lower than the benchmarked index. However, it is theoretically possible due to interplay of different parameters that tracking error is zero or even negative. In that case, the index fund may deliver returns superior to that of benchmarked index.
What are the advantages of index funds?
Index funds are typically used by investors who are risk averse. In comparison to actively managed funds, index funds have lower expense ratio, lower transaction costs, better control of risk through diversification and less prone to risk of fund manager’s performance.
Among institutional investors, index funds are used by pension and insurance funds. Amongst individuals, investors who do have knowledge of the markets or are averse to sector specific risks prefer index funds.