Are Index Funds for Me?

I am 48 year old and have 10 years to go for retirement. My question is, are index funds a good investment for a person like me? If so, what should be the selection criteria?

K. Venkatesan Iyer

The brief answer to your question is 'yes'. There's no reason why index funds shouldn't be an ideal investment for a person like you. Compared to actively managed funds, index funds are relatively low-risk-return equity instruments. However, don't lose sight of the fact that index funds are equity investments and would have the same characteristics as that of the equity asset class. Inspite of being a diversified instrument, they are still susceptible to market risk. Market risk stems from perils that affect the entire economy and cannot be reduced even by diversification.

By definition, index funds track a particular market index by purchasing all the stocks of that index in same proportions as they are in present in the index. This ensures a performance identical to that of the index they track.

As to the actual choice of index fund, you have two options. A fund which tracks the Sensex or one which tracks the Nifty. These indices consist of shares of the largest companies and are also the most liquid. In short —a portfolio of bluechips. You can also opt for an index plus fund. These invest 80 per cent of their assets into a particular index and the remaining 20 per cent is actively managed. HDFC Sensex Plus and LIC Sensex Advantage Fund are examples of this class of funds. Zurich India Top 200 is also such a fund. This scheme matches 60 per cent of its portfolio with the BSE 200.

The second decision is which index fund to buy? Currently, there are 10 fund houses, which offer index funds. We think the decision largely comes down to a matter of which fund house offers the lowest expense. Since, the index fund manager doesn't have to spend time and money on research and in monitoring stocks, costs should be low. While this will certainly be true in the long run, since most index funds are new, cost is yet to emerge as a strong differentiating criteria.

While examining costs, also do not forget to look out for the fund's tracking error. Tracking error measures how much an index fund's returns deviate from the benchmark index's return over any given period of time. The lower the tracking error, the better the fund is at keeping pace with its index. A poorly run index fund will generally have a large tracking error.

Do remember that index funds' advantages do not mean that this is the only kind of fund you should invest in. Well-run actively managed equity funds can give your returns a boost.

Especially when these have outperformed the index in the past three years. This is even more important in a market which rises and then keeps falling back to the same levels, as been happening with Indian markets for some years now. The index can end up at the same level over a number of years, effectively wiping out gains. Good actively managed funds should hold on to these gains, giving returns a boost over the long term.

Moreover, don't think that you have just got 10 more years of investing. Investing doesn't stops at retirement. Prepare your asset allocation plan and act accordingly.

This article was originally published on January 14, 2003.