Index Fund advanced- PART 2: The simple road to substantial wealth

February 11, 2022/ Advanced Topics

Can an Index fund benefit you? Well, lets ask some interesting questions.

Buying the haystack and the edge of Index funds

Do you want the best CEOs and companies in the nation to multiply your money for you?
How about some protection in case any of them perform badly?
Would you also like to benefit from future companies and CEOs that could come up over the next decade?
Do you want them to work for you for a long period of time?
Are you indifferent to fluctuations in value in the short term (or what I call the “crazy guy on the road shouting”)?
Do you want to have all this done at a cost of less than 50 paise out of every 100 rupees you invest?
Do you want to spend almost 0 time managing your investment?

If the answer to the above is “YES!” then an Index fund is probably useful to you. While an Index fund is the most direct method to own an interest in the long-term growth of India’s business ecosystem, there are a few nuances to understand. Let’s get started.

I. Buying an Index fund-recap

I thought a quick recap could help before we dive deeper into some terms and details. As discussed in Part 1, “the Index” generally refers to the two main Indices, the Nifty 50 and the SENSEX. Constituted from companies on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) respectively, these indices reflect the top companies in terms of free float market capitalization and liquidity. The Nifty 50 includes 50 companies and the SENSEX includes 30 companies.

We can buy them directly from the fund house/Asset Management Company (AMC) like on SBI’s portal , or from Registrar Agents like CAMS and or they can be bought in the ETF form on the open market using a broker like Zerodha or Groww. On we go.

II. How to pick an Index Fund?

As with any industry, in the mutual fund space (Index funds are one type of mutual fund), there are many sellers of seemingly the same product. Many banks and Asset Management Companies (AMC) like ICICI, SBI, HDFC and others engage in the business of collecting investor’s money (i.e., You and I) and then create an index fund basket by buying the stocks of companies in the Index in the same proportion. So, if they’re all doing the same thing, is one better than the other? Should we even make an effort to choose? I’d say yes. As with most things in life, some are good products and bad ones. Here are some factors to consider.

1. What is the underlying Index?

Banks and AMCs can setup an Index fund on various different Indexes. While the most popular and common are the SENSEX and NIFTY 50, there are more niche Indexes like the NIFTY Next 50, Small cap Indexes and Midcap Indexes. If you feel particularly strongly about a certain group of companies, then it seems logically to find an Index fund that is based on that Index. For example, my friend Rahul believes that the large Indian companies are too bloated and won’t grow much. He thinks the “next big thing” is small cap companies that are yet to be discovered and feels that they represent a great opportunity for long term growth. Thus, he picks the NIFTY 100 small cap Index and buys an Index fund based on this.

2. Tracking error

The job of an index fund is to match the returns of the underlying index. Tracking error shows how well the index fund does this- the lower the better. A tracking error is the difference between the rate of change of an Index over a time period and the corresponding rate of change of the Index fund over the same period. For example, if the NIFTY 50 rises 10% between 1 January 2022 and 31 December 2022, but the SBI NIFTY 50 Index fund rises 10.1% over the same period, the tracking error is +0.1%.

Large tracking errors (for a rough idea- the top Indian Index funds have a tracking error below 0.2%) indicate poor management. A tracking error can be positive (the Index fund delivers higher returns than the index) or negative (the Index fund delivers lesser returns than the Index). We don’t want either. A large deviation implies that the fund manager could be taking higher risk to earn more returns (too risky) or that he is failing to accurately match the Index and earning less return (inefficient). An Index fund investor wants the fund manager to merely match the Index.

Why does tracking error occur?

An index fund manager has to manage this complex basket of stocks on a real time basis. He/she must ensure that it matches the exact proportion of stocks in the Index while adjusting for many variable events like redemption by investors, dividends paid, changes in composition of the Index, and costs of running the fund. As a result, it is not a simple task and not as easy as just dividing the available cash fully among the index constituents. The true indicator of a good fund and thus a good fund manager is thus the ability to handle these moving parts while still ensuring that the fund’s Net Asset Value (NAV) moves along with the index’s rise and fall. This is what a tracking error figure denotes.

Note on comparing tracking error between different Index funds

One interesting thing to note- we cannot make accurate comparisons between two marathon runners if they run different terrains. This metaphor applies to index fund tracking error because fund houses may calculate this error in different manners. Some could take the NAV at the end of each day for 12 months, while others could take the NAV at the end of each month for 36 months. It’s important to keep this in mind while comparing tracking errors of potential investment. Rules and guidelines are needed to enhance uniformity and comparability. In the meantime, the alternative could be making the calculation yourself (or at least visiting the fund factsheet ) to stay aware.

3. Expense Ratio

There are no free meals. Did you actually think someone would go through the effort of making a basket of stocks, tracking the index, and rearrange them all for free? I wish.

The expense ratio indicates the cost to the investor to have his money in the index fund. It is represented as a percentage of the investment. An expense ratio of 0.5% means that for every 100 rupees you and I invest in an Index fund, 99.5 rupees is used to buy stocks in the proportion of the index while 0.5 rupees is used by the fund to pay salaries, bear costs of running the fund and meet transaction and logistics costs.

As an investor, ideally, we would like our money to be used to buy stocks and not meet expenses because we earn returns on the assets acquired and not on the expenses spent. However, the expenses are a necessity to run the fund and manage the money well. All else being equal, lower the expense ratio, the better. For example the SBI NIFTY 50 Index Fund, provided to investors as an ETF (explained next) has an expense ratio of 0.07%. This means that an awesome 99.93% of our money is put into stocks directly.

Typically, passively managed funds that track a market index cost investors a fraction of the amount that active funds charge. An active Indian large cap mutual fund in India can charge anywhere between 0.9% on the low end to 1.5% on the high end. Although they may seem small, these are staggering costs in reality as they compound over time (image above). To understand the impact of costs, check out this calculator for a better understanding of how a 1% fee can rob you of lakhs of future gains.

III. What is an Exchange Traded Fund (ETF)?

Like the term indicates, ETFs are mutual fund units that are traded on a stock exchange. They have qualities similar to stocks. In an Index fund, the units are bought and sold between the Fund house and investors and a Demat account is not needed.

Parties to an ETF transaction

In an Index ETF, the ecosystem expands to the stock market with an intermediary between the Fund house and the investor called an Authorized participant. The investor buys ETF units (same as Index units in structure and underlying value) from other investors or the Authorized participant. The Authorized participant buys individual stocks from the market and exchanges this for ETF units with the Fund house, which are then sold to the investor. In case the investor wants to sell ETF units, the AP buys these, delivers it to the Fund house and in exchange gets individual shares which it sells on the open market. This three-party process is crucial to ensuring liquidity and a way out/in for ETF investors.

Smallcase has a good explanation of this process with clear details and pictures. This is called the “creation” and “redemption” process.

Benefits of ETFs over an Index fund

1. Low cost

With ETFs, the costs associated to run the fund are usually lesser than their direct Index fund counterparts as the Fund house does not directly buy and sell individual stocks. They engage in what is called a “creation” and “redemption” process. Think of it like gift wrapping. When there is a spike in demand for ETF units, the AP buys individual stocks from the market and brings it to the Fund house to obtain ETF units. The Fund house basically takes this stocks, wraps them in “ETF gift-wrapping” paper and returns each wrapped unit as an ETF to the AP. This “gift-wrapping” and compacting process of individual stocks into ETF units is called “creation” of ETF units.

In reverse, when ETF units are sold by individuals, the AP buys these sold units from investors. They surrender these ETF units to the AMC or Fund house. The Fund house “unwraps” the unit and returns the underlying individual stocks to the AP who then can sell these on the open market. This “unwrapping the ETF unit” is called the “redemption” process. In India, unlike other parts of the world, this creation and redemption process between the Fund house and the AP is not taxable allowing the fund house to save money and still infuse and maintain liquidity in the ecosystem for buyers and sellers of index funds.

2. Liquidity

ETF units are traded freely on the stock exchange and can be bought and sold in real time. Further, we have the option of buying odd lots. We can buy one unit, three units or any other random number. Directly buying Index funds usually requires a minimum buy-order that could be as low as 500 rupees. ETFs also allow us to sell units on the open market at will, subject to there being an active buyer-market for them.

3. Easy through Demat account

No additional paperwork is needed if you already have a Demat account. You can simply enter the ticker symbol (like SETNIF50) and buy the ETF you want.

Drawbacks

Unlike in more developed capital markets in the West like the US, the ETF liquidity ecosystem is still in its nascent stages and thus only a few of the large ETFs like the NIFTY 50 ETF have sufficient safe liquidity. What this means is that not all ETFs have Authorized Participants waiting to buy and sell these ETFs. They may avoid smaller ETFs because the lack of investors means they cannot make money on the transactions. This obviously is a chicken-egg situation as one requires the other. Thus, you a as a seller or buyer may have accumulated a large number of ETF units and may find yourself stuck if there are no willing buyers or sellers. This is one risk with buying ETF units of lesser-known indexes and sectoral funds. Long-term investors could consider directly buying units of index funds where they represent smaller indexes or niche sectors.

Further, where liquidity is low and few Authorized Participants exist, the bid-ask spread, or what the Authorized Participant quotes as the buy/sell price could be significantly different from the ETFs NAV price. Thus, investors may end up paying a premium to buy and may sell at a discount. This hidden cost is more prominent in case of ETFs of small Indexes or niche sectors. Liquidity and hidden cost are inversely proportional here.

IV. Conclusion

Hopefully you’ve read till this point. Index funds of a growing country like India are a great long term growth prospect. In the short-term, there will be serious price fluctuations and these smoothen out in the long-term. Buying and Holding these Index fund units is essential to benefitting from the long-term compounded growth. This can happen only if we understand what they are and how they value. A basic education and awareness of the details of an Index Fund are essential to taking action, staying invested. and ultimately benefitting financially.

I hope this was helpful and congratulations on taking the interest to further your financial literacy!

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