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Should one invest in Index Funds?

Published on Fri, Feb 02, 2007 at 14:46 | Source : Moneycontrol.com

Updated at Fri, Feb 02, 2007 at 15:21

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Rainfall in city yesterday was 43 mm, read a newspaper weather report. Rainfall is a representative number. Some parts of city could have received rainfall more than 43 mm. There could be some areas, which would have received less than 43 mm rainfall. However if in general, rainfall received is around 43 mm, it is suppose to be appropriate representative number. This number also helps in comparing the changes. E.g. rainfall received on same day last year was 47 mm. Therefore this year city received 4 mm less rainfall.

Stock market index is also a representative number. When we say Nifty has moved from 3990 to 4085, the movement is of 2.38%. There could be some stocks, which could have moved more than 2.38%, and some would have had lesser movement. However as long as majority of stocks have had movement of around 2.38%, representative number is of relevance. (Also read - Align your portfolio to your needs; not market needs)

In India, till 1986 there was no stock market index. Imagine, how would investors know the level of stock market without benchmark index? In the year 1986 BSE compiled Sensex with base year 1978-79=100. Today Sensex, which is at 14000 levels, was at 100 in 1978-79.

Once upon a time there used to be a joke about a villager who wanted to invest (buy) not in any company stock but in BSE Sensex, as that kept moving upwards. Today that is possible through index funds.

What is an Index Fund?

Index funds are those equity funds that invest in the constituents of an index and in same proportion as their weightage in index. Sensex consists of 30 stocks (constituents.) An index fund tracking Sensex will invest in those thirty companies, which are constituents of Sensex, and in same proportion as their weightage. (Also read - Learn to invest in equities with 'no capital risk')

Concept of index funds for common investor was first conceived by John Boggle in 1976. He had earlier studied, as part of his senior thesis in Princeton University that:

The order of top-performing funds is continuously changing. This means there isn't any mutual fund scheme, which consistently remains in the top-performing category year-on-year. Also, it is only in hindsight that one will know which funds were top performers in the previous year.
Sales, marketing and other administration expenses are eating away returns generated by fund managers.
All fund managers are not consistently able to beat market returns (read indices returns).

Therefore he thought it is not worthwhile to pay higher expenses to mutual fund schemes and let fund manager do the stock picking. By controlling expenses and eliminating the research and stock selection investor could generate better returns. Index funds only invest in constituents of index and hence fund manager and his team does not have to use their skills in research and stock picking. He found a mutual fund company called Vanguard and launched index funds. Concept of indexing is very popular in matured and efficient markets.

What is an efficient / inefficient market?

Efficient market is one where all investors know information about a particular stock and therefore every investor takes informed decision. In an inefficient market only few investors know about the company information and hence they benefit. (Also read - Mutual Funds: Your best personal Portfolio Manager)

Assume there is a classroom where a particular subject is taught. All students in the class get same amount of knowledge as the teacher is imparting it. Next day if there is exam each student will get different marks based on their writing ability, neatness and presentation skills etc. However no student will be to produce more knowledge about the subject than rest of the class as teacher has imparted same amount of knowledge. Similarly in efficient market, information about company is available to individual investor is same. There could be some investors who will make more money than others based on amount funds they invest, time at which they invest etc. but all would be reacting on the same information available.

Suppose in our above class, teacher also gives private tuition to some students. Also there are students who are attending some coaching classes. These students will have more information about the subject than other fellow students and hence in next day exam they will be able to produce more information. This situation is like inefficient market, where some investors get information about particular stock faster and hence can capitalize on the information better. (Also read - Is Risk eating into your portfolio?)

In reality there can never be complete efficient or inefficient markets. (In theory there are three forms of market efficiency, weak form of efficiency, semi-strong form of efficiency and strong form of efficiency.) However as we move from inefficient to efficient market fund mangers will struggle to continuously beat the benchmark index. One of the reasons for this will be that information about stock will be more or less efficiently available to all large and small investors. Under such circumstances index funds will be better bet for investors.

- Gaurav Mashruwala

The author is a Certified Financial Planner. He may be reached at gmashruwala@gmail.com

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