Index schemes

Talk to a bunch of financial advisors about your retirement plans and chances are that some of them would ask you to start investing immediately in a low cost index scheme to build your corpus. Lately, there has been a surge in number of financial advisors advocating index schemes as the best way to build nest eggs to take care of long term financial needs: be it your child’s education abroad or your own sunset. However, most of them concede investors still have a fascination for the actively managed equity schemes vis-à-vis index schemes which are a form of passive management. Index schemes don’t take call on individual stocks; they simply invest in stocks that form the Index that too, in exactly the same weightage.

As India becomes a more efficient market, fund managers would find it increasingly difficult to beat the indices consistently over a long period of time. If you look at the current trend, there would be schemes which may manage to outperform the index for a short while, but it may not do for a long period consistently. That is why you see constant changes in top performing schemes these days.

Why one should pay extra to a fund manager when he is unable to beat the market benchmark on a consistent basis. The whole idea behind giving a higher fund management fee in an actively managed fund is to get superior returns. But if it is not happening, then there is no point in paying a higher fee. That is why many advisors like him believe investors would be able to make better returns from an index fund where the cost could be lower by 1–1.5%. When you are speaking about a long term of 15 years, savings could be quite huge.

However, don’t think the concept is universally accepted. Many investment experts as well as fund managers argue that they can still beat the market. India is still an emerging market. We are nowhere near the US or other developed market you have to really struggle to beat the market over a long period. If you look at the performance of actively managed schemes like diversified or large cap schemes outperform the indices in a period of 3-5 years. Critics cheekily point out the mutual fund disclaimer in reply: Past record doesn’t guarantee future performance.

How does one choose the best index scheme from a plethora of schemes available in the market? Investing in an index scheme may be a passive form of investment, but choosing one definitely is not something you should do casually. Investors must place emphasis on the cost and the tracking error of these schemes before putting in the hard earned money. Tracking error happens because the scheme may be keeping aside a part of its corpus in cash to face redemptions. Also, they may be buying shares through the day but the valuation may reflect only the closing prices. So it is important for an investor to review the performance of the index scheme for a medium to long period before putting in the money. If a scheme is trailing the index for a long period, it is best to avoid it.

Future Perfect
1) Index schemes are a passive form of investment
2) They invest in stocks that form the index
3) Many investment gurus believe one can’t beat index consistently
4) Index schemes are cost effective compared to actively managed schemes
5) Investors also need not bother about the performance of the fund manager.