Art of Imitating, essential for success of Index funds and ETFs!!

Most of us in our lives have ideals (an individual) that we try and imitate as closely as possible. May it be our personal lives, sports or workplace we tend to seek the qualities of our ideal in one way or the other? The ideal person has so much of an impact in our lives that at some point in time we try to evaluate ourselves or our progress with that of our ideals’ in day-to-day life.

 

However, the evaluation with our ideal has many shortcomings. There may be vast differences in terms of health, wealth, personality traits, etc as compared to that of the “ideal”. And unfortunately there are no standard measures or properties which can ascertain the closeness with our ideal.

 

Going on the same footsteps are Index funds (a category in mutual funds) who have predefined benchmarks (ideals) to imitate or replicate as closely as possible in terms of their composition and performance.

 

At this juncture, let us first understand what are Index Funds?

 

Index Funds are a category in mutual funds which passively manage funds with the sole purpose of replicating or imitating their benchmark indices – be it BSE Sensex or the S&P CNX Nifty. They replicate the benchmark indices by being invested in portfolio of stocks by assigning same weights as the stocks enjoy in the respective index. Hence, by doing so the fund manager takes minimum efforts as regards stock selection is concerned, thus engaging into passive management.

 

Also worth mentioning at this point, is another category of mutual funds which are passively managed – Exchange Traded Funds (ETFs). ETFs are similar to index funds, since they to tend to mirror their benchmarks at all times. But, the difference lies in their liquidity. ETFs as the name suggests are traded on the exchange, thus enabling an investor to buy / sell units at the traded NAV (Net Asset Value) subject to both parties to the trade being available. Whereas in case of an index fund, purchase or sale happens at the end of the day’s NAV, and you have to approach the mutual fund house to transacting in them.

 

Now, that we are aware of the passively managed category of mutual funds, let us probe deeper into how effectively these funds replicate their respective benchmarks. Going by their definition and what they mean, you investors may be in an illusion that choosing an index fund or an ETF is just a piece of cake. Well, there is something more which goes into selection of an index fund or an ETF – and mind you it goes even beyond assessing their performance.

 

Report Card

* ETF: Exchange Traded Funds
Data as on May 9, 2011
(Source: ACE MF, PersonalFN Research)

 

The most significant factor in determining the worth of an index fund or an ETF is its tracking error. Tracking error is the measure of how closely a fund’s portfolio mirrors the index to which it is benchmarked. The lower the tracking error of a fund the better it is in replicating its benchmark index.

 

However, the tracking error does not always capture all the deviations from the benchmark index. This is due to the fact that it is influenced by a number of factors.

 

Let us go through these factors one by one.

 

• Cash Component: The cash balance maintained in a portfolio is one of the major reasons in deviation of the returns. The lower the cash component, the closer the fund can track the index.
  
  Let us understand this by an example.
  
  Given that the benchmark index moves up by 1% in a given day, an index fund holding 1% of its AUM in cash will move up only by 0.99%, while another fund holding 10% cash component will move up only by 0.90%. In other words, the cash component will result in these funds underperforming the index in a rising market and outperforming the index in a falling market. So it always makes sense to stick with an index fund with a lower cash component.
  
  Hence, as an investor you need to keep a close eye on the cash balance of these funds.
   
• Fund size: Larger the size of the fund, the better is its position to manage the portfolio efficiently. Higher AUM makes management of inflows and outflows easier as a larger corpus facilitates better cash movement. So it always makes sense to stick with an index fund of a significant size.
   
• Expense ratio: Predominantly index funds and ETFs are passively managed and as a result have lower management fees. This is reflected in the expense ratios which typically range from 0.5% to 1.0%.
  
  Thus as an investor, you need to look out for funds having low expense ratio. And unlike the other two factors (i.e., cash component and fund size), this will remain a major drain on the scheme. Thus, investors need to avoid a fund which has a high expense ratio even if it has a lesser “declared tracking error”, because it is most likely to underperform the benchmark index in the long run.
   
• Composition: An index fund or an ETF having a benchmark as BSE Sensex or Nifty will definitely enjoy more liquidity in the stocks it owns. This is because the components (stocks of companies) in Sensex or Nifty are widely traded and as such entering and exiting these stocks is an easy affair (this helps in keeping the tracking error low).
  
  In contrast to this, when a fund is replicating a less liquid index like Nifty Junior, it might get caught up with funds which are not widely traded and as such face liquidity issues due to difficulty in entering and exiting these stocks.

 

So, the next time you think of investing in an index fund or an ETF remember that there is more to look into than just going by the performance and their tracking errors.

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