A

Beginner’s
guide to
Index
Funds
 Investing in Index Funds

The Basics of a Mutual Fund

A mutual fund is a type of investment vehicle consisting of a portfolio of

stocks, bonds or other securities. Mutual funds give small investors access
to diversified, professionally managed portfolios.

Using Mutual Funds, investors have two main investment strategies that
can be used to generate a return on their investments - Active portfolio
management and Passive portfolio management.

Active portfolio management focuses on outperforming the market

compared to a specific benchmark, while passive portfolio management
aims to mimic the investment holdings of a particular index.

This guide consists of two parts:

 The first part highlights the difference between Active and Passive
Funds.
 The second part discusses about Index funds and ETFs which come
under passive funds.

@indiaetfs
The image below gives you an overall idea what this guide is all about.

 Know about Active Funds and Passive Funds.

 Understand why passive funds are better than active funds.
 Difference between Index Funds and ETFs.
 Why choose Index Funds and how to invest in them?

Mutual
Funds

Active Passive
Funds Funds

Index
ETFs
Funds

How to
Invest?

@indiaetfs
 1. Active and Passive Funds

Active Funds are regular equity mutual funds, you are familiar with. It
is a mutual fund in which a portfolio manager makes decisions about how
to invest the fund's money. The fund manager buys and sells stocks
actively, in an attempt to make higher returns.

The success of an actively managed fund depends on combining in-depth

research, market forecasting, and the experience and expertise of the
portfolio manager.

Since the objective of a portfolio manager is to beat the market or get

higher returns, he or she must take on additional market risk to obtain the
returns necessary to achieve this end.

 To measure the performance of a mutual fund, a benchmark index is

used.

For example: ABC fund is benchmarked against NIFTY 50 index, the

performance is measured as follows:

If the ABC fund’s 1 year returns is 10% and the NIFTY 50 returns is 12%,
the fund is said to have underperformed the benchmark index (2% lesser
returns). And vice-versa.

In other words, returns from active funds could be higher or lower than the
benchmark index, depending on the fund manager’s performance, the
fund’s expense ratios and so on.

@indiaetfs
Note: Expense ratio plays an important role in active funds. It indicates
how much the fund charges in terms of percentage annually, to manage
your investment portfolio.

If you invest Rs. 20,000 in a fund which has an expense ratio of 2%, then it
means that you need to pay Rs. 400 to the fund in order to manage your
money.

If a fund returns equal to 15% and has an expense ratio of 2%, then you
would get a return equal to 13%. The Net Asset Value (NAV) of a fund is
reported after deducting all fees and expenses. But still, it is important to
know that how much are you paying to the fund.

Pros of Active Funds:

• Opportunity to outperform index.

Cons of Active Funds:

• Potential to underperform index.

• Generally higher fees.

@indiaetfs
Passive Fund, as the name suggests, follows a passive investment
strategy – it just invests in an index. Its portfolio will reflect the
constituents of the index in their exact proportion in the index.

A passive strategy does not have a management team making investment

decisions. There are no frequent buying and selling of stocks, hence
reducing the costs substantially.

The performance of a passive fund will be that of the index it has been
benchmarked.

Pros of Passive Investments

 Likely to perform close to index.

 Eliminate manager risk.
 Generally lower fees
 Simplicity: investors know what they are getting.

Cons of Passive Investments

• Unlikely to outperform index

@indiaetfs
Why choose Passive funds over Active funds?
The comparison table below gives you the key differences and why you
should choose Passive funds over active funds.

Active vs Passive Investing

Key
Factors
Active Passive
Fund Manager risk High Low

Costs Involved High Very low

Emotion & Bias High Low

Performance Majority Same as

relative to Index underperform benchmark

Risk Unknown Only market risk

The above table clearly indicates the advantages of passive investing over
active investing. Key factors supporting passive investing are – low cost, no
fund-manager-risk and simplicity. There shouldn’t be any doubt that
passive investing should be the first choice for new investors.

@indiaetfs
2. Index Funds and Exchange Traded
Funds (ETFs)

Hope, investors are convinced of the fact that, why passive investing should
be the first choice for them. Let’s proceed to know how Index Funds and
ETFs help in using the passive investment strategy.

Before we read about Index Funds and ETFs, a short explanation about
what an Index is and how it works.

What's an Index?

Investors and other market participants use indices to track the

performance of the stock market. An index is a list of stocks that is
assembled based on some set of rules.

For example, the NIFTY 50 is a list of the top 50 stocks, by market

capitalization, traded on the National Stock Exchange. The Index tracks the
behavior of a portfolio of blue chip companies, the largest and most liquid
Indian stocks.

The NIFTY 50 covers major sectors of the Indian economy and offers
investors exposure to the Indian market in one efficient portfolio.

Another popular index is the NIFTY Next 50, a collection of next-50 stocks
from NSE.

And similarly for Bombay Stock Exchange, the BSE 30 represents the top
30 stocks in the BSE.

There are indices based on market capitalization (large-cap, mid-cap, or

small-cap), sector (e.g., banks, technology, public sector units) and so on.

@indiaetfs
List of top NSE Indices.

Investors can invest in Index Funds of any the above indices, provided
there is an Index fund or ETF available.

@indiaetfs
How do Index Funds work?

An index fund works a lot like a typical mutual fund. When an index fund
tracks a benchmark like the NIFTY 50 index, its portfolio will have the 50
stocks that comprise NIFTY, in the exact same proportions.

In an active mutual fund, the fund manager actively manages positions with
lot of buy and sells decisions, trying to maximize the returns for the
investor.

Whereas in an index fund the fund manager just buys the index stocks and
holds it. This can save investors a lot of money because there’s no frequent
buy and sell decisions.

For example: Consider a year back NIFTY 50 index was at 10,000.

If you would have invested Rs.10,000 in a NIFTY 50 Index Fund, today

your investments would be worth Rs,11,600, since the index now is at
11,600.

Isn’t it that simple?

Note: The investment would be worth 11,600 minus the expense ratio and tracking error (expense ratio
and tracking error explained later)

@indiaetfs
What's the difference between Index Funds and ETFs?

An investment in an index can be made either through Index Funds or

ETFs.

 An Index Fund is similar to a typical mutual fund. Units of any

Index fund can be directly purchased from the mutual fund houses at
a fixed price called Net Asset Value – NAV.

 ETFs are Exchange traded funds of any Index, where their units are
traded on a stock exchange like NSE or BSE. Like shares of public
companies, they can be bought or sold anytime during the trading
hours of the stock exchanges.

What are the other factors involved in choosing Index Funds and
ETFs?

 Cost

For buying or selling Index Funds, the transaction cost is zero. You usually
don't have to pay a commission or transaction charges to buy an index
fund, as they are sold directly by the mutual fund companies.

However, to buy ETFs you need an account with a stock broker. There are
other costs involved like impact cost, brokerage charges every time you buy
and sell units, DMAT charges, annual maintenance charges etc.

@indiaetfs
  SIP - Systematic Investment Plan

SIP is an easy and automated way to buy units at regular intervals and this
method can be used to buy Index Funds.

In case of ETFs, SIP cannot be done. The investor has to buy every month
regularly from the stock market, through his stock broker.

 Expense ratio

As such, Index Funds typically have low expense ratio - the percentage of
assets paid to the mutual fund company. For example, UTI’s NIFTY 50 and
HDFC’s NIFTY Index Funds have an expense ratio of just 0.1%.

ETFs have lower expense ratio than Index Funds like 0.05%, but as the
transaction costs could be involved, the expense ratios for both could be
similar.

 Tracking Error

Tracking error is the standard deviation of the difference in returns

between the Index fund and its benchmark Index.

Index Funds have a tracking error (like 0.1% in NIFTY 50), whereas ETFs
rarely have that error.

@indiaetfs
  Why choose Index Funds and not ETFs?

ETFs are no doubt an efficient to way to invest in Indices. ETFs are very
popular with US investors where are they are cost-effective as well as
convenient to invest.

But, in India ETFs are yet to reach retail investors in a big way.

Since ETF volumes traded in stock exchanges are low, investors find it
difficult to buy and sell them easily. Whereas one could buy an index fund
with ease and convenience.

Index Funds are cost effective, convenient and it’s possible to invest
systematically, making it the first choice for new investors.

Who should invest in Index Funds?

If an investor wishes to participate in equities but don’t wish to take the

risks associated with stocks or actively-managed equity funds, he/she can
choose an index fund.

These funds do not require extensive tracking or monitoring.

Index funds are generally considered ideal core portfolio holdings for
retirement portfolio.

@indiaetfs
Which Index funds to select?

The NIFTY 50 is the flagship index on the National Stock Exchange of India
Ltd and NIFTY Next 50 comes next. These 2 indices cover the top 100
companies traded in NSE India.

The investment decision in a mutual fund solely depends upon your risk
preferences and investment goals.

Once you have decided about your investment goals and how much to
invest, you can select the above two mentioned index funds.

New investors can consider investing in Nifty 50/ Nifty Next 50 or both in
50-50 ratio. Index funds have performed well over long term and have
offered inflation-beating returns, if invested for 10 years.

How to invest?

 Many mutual fund houses like UTI, HDFC, Reliance, DSP, SBI, ICICI
and others offer index funds for the above indices.

The investors can choose NIFTY 50 Index Fund and NIFTY NEXT 50
Index Fund from any fund house of their choice, with low expense
ratio and low tracking error.

The list is available here.

 The investor can invest in Growth Fund – Direct option, directly from
the website of the mutual fund house.

@indiaetfs
Index mutual funds are easy to understand and offer a relatively safe
approach to investing in broad segments of the market.

 Buy them every month through Systematic Investment Plan (SIP).

 Stay invested in them for a very long duration.

 When markets are battered or down – do not panic, keep investing

regularly. This will help you average your cost of investment.

 Before concluding, let us remember the legend John Bogle, founder of

the Vanguard Group and a major proponent of index investing.

Commonly referred to as 'Jack', Bogle revolutionized the mutual fund

world by creating the world's first index mutual fund, enabling
investors to achieve high returns at low costs.

It is because of him, passive management now accounts for 45

percent of all assets for U.S. stock-based funds. Investors have turned
to ETFs and passive mutual funds in large part because of their lowest
cost.

 Finally, a quote from another legendary investor Warren Buffett on

Index Funds:

"By periodically investing in an index fund, the know-nothing

investor can actually outperform most investment
professionals."

That’s all folks!

@indiaetfs
This is a basic guide on Index Funds. There is nothing here which can’t be
found on the internet.

Just trying to make things easier for new Index Fund investors, especially
from Indian investors’ point of view.

Hope you would have found this guide useful. Please share it with your
friends.

For feedback, comments and views: etfsindia@gmail.com.

In near future, hope to bring out a detailed guide about investing in ETFs
and other advanced Index products

For now, let us keep it simple!

Thank you!

For more news and updates on Index Funds and ETFs check out
https://www.twitter.com/indiaetfs

Disclaimer:
All of the information in this guide is for informational purposes only. The opinions in this document
should never be construed as specific investment advice or as recommendations to buy or sell any
securities. Conduct your own due diligence before making any financial or investment decisions.

@indiaetfs