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Index Funds

While investing in an index fund, the key is to choose an index appropriate to your investment need, and then go for a fund based on its tracking error and expense ratio

I want to invest in index funds. But there are so many of them available. Moreover, their one-year returns are more or less similar, making it difficult to choose a good fund. Can you help me with that? Also, can you tell me if there are any ETFs available and how can I invest in them?
-R Ramabadran

While investing in an index fund, first decide which index you want to invest into. Currently, the choice is quite limited on that front. A majority of index funds track either BSE Sensex, or the S&P CNX Nifty. There is just one fund each tracking Bank Nifty (a banking sector index) and CNX Nifty Junior (it comprises 50 most liquid stocks after excluding the constituents of S&P CNX Nifty). You may choose a good index fund on the basis of its tracking error and its expense ratio.

Tracking Error: An index fund simply mimics a market index, making sure that the fund has exactly the same holdings in exactly the same proportions as the index on which it is based. This process of mimicking an index, however, is not perfect. There are a number of factors that may make the fund's holdings, and therefore returns, deviate from being exactly the same as the index.

Tracking Error is a measure of such deviations. It tells us how much an index fund's returns deviate from the benchmark index's returns over any given period of time. Since an index fund is supposed to provide the same returns as the index, tracking error is a good way of measuring how well an index fund is run. A well-run index fund will generally have a small tracking error.

Expense Ratio: Index funds tend to have lower expense ratios as compared to actively-managed funds, since there is little that an investment management team has to do apart from ensuring that their portfolio is exactly similar to the index they track. But you might come across index funds which charge exorbitantly for the little effort required to run an index fund. Moreover, in a category where returns of the various funds tracking the same index are bound to be similar, a lower expense ratio can add that extra basis points to the returns.

There are exchange traded funds (ETFs) available in India, though the choice is quite limited. Benchmark Mutual Fund specializes in ETFs. Among its equity offerings, it has Nifty Benchmark ETS, Banking BeES and Nifty Junior BeES. Apart from that, there are two more ETFs- Prudential ICICI SPIcE and UTI Sunder. The mode of transaction in an ETF is same as in case of a stock. You can buy and sell them on the stock exchange through a broker.

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