Not Peter Lynch or a Warren Buffett? Try Index Funds

Are you a peter lynch or a warren buffett?

photo by thelastminute

Everyone might be familiar with mutual funds especially ELSS (Equity Linked Savings Scheme) coz that seems to be one of the favourites with salaried-class people. After all, it’s eligible for that deduction under Section 80C and plus has a potential to give you returns far better than traditional investment avenues such as Provident Fund (PF) and National Savings Certificate (NSC). However, investing in ELSS means a lock-in period of 3 years.

Consider this – you’ve already invested in ELSS and have some extra money that you wish to invest in stocks. You could be one who is a pro when it comes to investing directly in stocks. Or you could be someone who depends on friends / family for guidance. Then there are times when you really don’t have the time to track the stock market, more specifically, trying to figure out which are the stocks that you should ride your money on. In such a case, index funds are a good avenue to look at.

What is an index fund?

The average opinion of the stock market is expressed through a stock market index. While following an indexing strategy the idea is to try and earn similar returns as given by a stock market index. One way to execute this strategy is by investing in constituents of a stock market index in the same proportion as their proportion in the index. But, this is a complicated strategy for individual investors as weight-ages keep changing and the investor will have to keep adjusting investments all the time. The other way is to invest in an Index fund – a mutual fund that collects money from investors and invests in stocks that make up a stock market index in the same proportion as their proportion in the index.

What is the logic behind an index fund?

It’s very difficult for an investor to keep beating the market. In the last two decades more than 85% of the fund managers in the United States have underperformed the S&P 500, one of the most broad-based indexes in the US. May be a Peter Lynch or a Warren Buffett can keep doing it all the time, but of the lesser mortals very few are able to do it consistently. Given this why not just ride the market? And this is the very reason that led to the innovation of an index fund.

As the US equity markets evolved, mutual fund managers realized that it was becoming more and more difficult to beat the indices, net of commissions, trading costs and taxes. Many mutual fund managers started buying stocks that constituted the various indices in the same proportion. And this became known as closet indexation. Out of this concept of index funds evolved. John Bogle was the first to launch an index fund. It was called the Vanguard 500 and it was an index fund based on the S&P 500.

What makes an index fund attractive?

Another reason that makes index funds attractive is their lower expense ratio. Expense ratio represents the expenses of the mutual fund expressed as a percentage of the total assets. Index funds do not require the services of high price fund managers or any sort of research. This tends to keep the expense ratios of the fund low. The Vanguard 500 index fund in the US has an expense ratio of 0.18%. The index funds in India do not have such low expense ratios but they are low vis-a-vis other funds.

Do index funds show returns exactly the same as indices?

All index funds do not return as much as their benchmark index. This difference between the returns from the index fund and the returns from the index is known as tracking error. This error occurs because of two reasons – the index fund may not fully track the index plus the index fund will have transaction costs to take care of.

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Author: Austin Comments: 0 comments Date: 6 Sep 2008
Categories: Investing Tags: , , , , ,
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