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Index Funds DTT

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Kiran Kumar
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18 views

Index Funds DTT

Uploaded by

Kiran Kumar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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What is an index fund?

What are the


disadvantages?

When you invest in an index fund, the fund


manager of that index fund uses your money to
invest in stocks in the same proportion as the
index that he is tracking.

Example -

A NIFTY Index Fund invests in stocks of companies


comprising the NIFTY 50 Index in the same
proportion and aims to achieve a return
equivalent to the NIFTY 50 Index.

For instance, as Reliance has a 10.3% stake in the


NIFTY 50 index, the fund manager of a NIFTY
Index Fund will build a portfolio where the
weightage of stocks of Reliance company will be
10.3%.

Similarly, stocks of other companies will be held in


equal proportion to the index.
Due to this style of investment, Index Funds have
some advantages. And like any other investment
product, it has some limitations as well. Let’s look
at the disadvantages first.

Disadvantages of Index Funds

The fund manager in an Index Fund must invest in


all the stocks in the same proportion as it is in the
index.

So if the index has only limited stocks or one stock


has higher weightage, then the portfolio might
not be optimally diversified.

Besides, even as the fund managers know that a


stock will fall due to certain circumstances, they
cannot take any immediate action t remove that
stock from their portfolio.
Advantages Of Index Fund

1. Low Fees

Index funds replicate an index; therefore, there is


no need for a team of analysts for research and
helping fund managers find stocks to build a
portfolio. Moreover, there is no active buying and
selling.

All these factors reduce the expense of managing


the fund. And these low expenses translate into
low fees for investors.

2. No Bias In Investing

Index funds follow an automated, rule-based


investment methodology. The fund manager has a
defined mandate on where the money goes and
how much he/she needs to follow. This removes
the human bias/discretion while taking
investment decisions.
3. No Need To Find The Best Fund Manager

Given the minimal involvement of the fund


manager, investors do not need to scout for the
best fund managers. As an investor, this is a big
relief because you do not need to check the track
record of several fund managers, their investing
style, etc.
How to Select Best Mutual Funds with Lowest
Expense Ratio
The expense ratio is an important factor to
consider before shortlisting a fund for investment.
Since a high expense ratio can have an impact on
the net return. The expense ratio is the per-unit
cost of managing a mutual fund. It is the ratio of a
mutual fund’s total expenses to the fund’s total
assets under management. When a fund’s asset
under management is smaller, the expense ratio
will be higher. Alternatively, if a mutual fund has a
high asset under management, the expense ratio
will be lowest.

For example, a total expense ratio of 2.25%


means that 2.25% of the fund’s assets will be
utilized to cover its operating expenses every
year.
You can explore our article on Mutual Fund
Charges
As per SEBI’s guidelines, mutual fund houses can
charge a certain fee to cover operational
expenses such as management fees,
administrative charges, marketing and
distribution expenses.
Building and managing a mutual fund requires
thorough and continuous research. The fund
manager and his team of professionals are on the
job to ensure that investors generate significant
returns from their investments.
When a fund’s asset under management is
smaller, the expense ratio will be higher.
Alternatively, if the fund has a bigger asset under
administration, the expense ratio will be lower.

Is Expense Ratio an Important Factor to Consider


While Investing?
Yes, the expense ratio is one of the important
factors to consider while investing in a mutual
fund. To elaborate, if a fund is able to generate a
13% return, but the expense ratio is 2.25%, the
net return for the investment would be 10.75%.
While a fund that generates the same returns but
has a lower expense ratio of 1.5%, the net return
from this fund will be 11.5%.
Thus, it is often preferable to invest in a fund with
a low expense ratio to enjoy maximum returns
from your investment.
A higher expense ratio indicates that the
management is using higher funds to manage the
mutual fund. On the contrary, a lower expense
ratio indicates lower resources are used to
manage the mutual fund.
Say you are investing INR 10,000 in a mutual fund.
The expense ratio of the fund is 2%. You will be
paying INR 200 to the fund house. This sum may
appear insignificant if you are considering a short-
term investment, but this amount will be
compounded if you invest for the long term (10
years or more). You will notice that you could
have had better results if you had invested in a
fund with a lower expense ratio.
Therefore, it is important to consider the expense
ratio as one of the parameters while choosing a
fund to invest in.
How To Reduce Expense Ratio on Your
Investment?
It is quite certain that the expense ratio will lower
your returns. Thus, a lower expense ratio
translates to lower expenses and higher returns.
Even a 1% difference in expense ratio might
significantly impact the final corpus. You have no
control over how much a fund house can charge.
However, the choice of fund is definitely in your
control to pick a fund with a low expense ratio.
Following are the ways to lower the expense ratio
on your investments:

1. Pick Funds with Low Expense Ratio


Select funds with the lowest expense ratio in that
category. The information is available from both
the fund and AMFI. While shortlisting funds
belonging to a category, give some weightage to
the expense ratio as well. In other words, say you
have shortlisted 2 funds belonging to one
category. Both the funds perfectly align with your
investment goals. Now, to choose between the
two, you can pick the fund with the lowest
expense ratio to maximize your returns.

2. Invest on Passive Mutual Funds


Passive investing is another way to invest in funds
with the lowest expense ratio. Actively managed
funds often have a higher expense ratio because
the fund manager constantly churns the portfolio
to generate higher returns. Therefore, passive
funds such as index funds or ETFs that aim to
track a benchmark index have a lower expense
ratio. These funds just try to replicate the
benchmark index as closely as possible, and
therefore, fund management expenses are lower.

3. Select Direct Mutual Fund Schemes


Instead of regular plans, you can choose direct
plans to lower your expense ratio. This eliminates
the need to pay for marketing and commissions,
lowering the expense ratio. However, direct plans
are suitable only for those investors who have
knowledge about mutual funds and have the time
to manage their investments. If you lack any of
the two, it is better to invest in regular plans.
Since the right choice of funds, right entry and exit
strategies suggested by an advisor will help you
generate higher returns. Thus, a small percentage
of expense becomes negligible in comparison to
the returns you will be generating with
professional advice.
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