Monday, November 8, 2010

index fund is better for beginners

The markets have given more than 150% returns since the lows of March last year and well in excess of 20% so far this year. The sprightly surge by the markets means that investors, who aren't comfortable with stock picking and the idea of keeping a close eye on their portfolio, can gain by simply putting their money in a fund that closely tracks key indices such as the sensex and the nifty.

While a vast majority of diversified equity mutual funds (MF) have done better than the key indices in the long run, index funds are a good option for investors who are new to the market, say industry experts. 

"First-time investors can opt for sensex or nifty-based funds as they have a good exposure to large-cap stocks and don't cause undue volatility," says Rupesh Nagda, head, investments and products, Alchemy Capital Management, a wealth management firm. 

Many first-time investors tend to go by the fund rankings and performance before choosing an MF product, he says. While performance assessment is a handy tool for making an investment decision, it is useful only if the comparison is done on a long-term basis—say at least five years, according to experts. 

Many investors often take short-term returns as the benchmark for making a choice without understanding the high risks involved, they say. "A newcomer would not be able to understand where to invest given the complexity and the sheer number of equity funds in the market," says Nagda. 

"Index funds are simple to understand and correlate closely with the returns offered by the market. Entry-level investors can put a good part of their money in these funds," says Anil Rego, CEO, Right Horizons, a wealth management firm. 

Index funds also have lower management costs. While charges for an actively managed fund come to around 2% of the MF's net asset value, it is between 0.5-1% for index funds. These passively managed funds provide returns that closely correspond to the gains made by their respective indices and have a tracking error (difference between index and fund returns) of 0.5%. 

These funds also have a lower risk-return ratio compared to actively managed equity funds. Index funds typically give lower returns in a rising market but fall less sharply during a downturn, say experts. Though index funds are popular in developed markets, it is not the case in India due to the lack of market depth, say observers. 

However investors, who are keen on higher returns and have a good idea about the market dynamics, should keep off index funds, say observers. "Diversified funds would always do better than the index in the long run," says an analyst. New investors can park up to 25% of their corpus in index funds. But seasoned market participants would be better off if they stay away, says another market observer.