Investors put their money in mutual funds with the expectation that the scheme will deliver better returns than the benchmark index and their category peers as well.

Investors bear the fund management charges primarily to get alpha returns. But in reality, there will be funds that underperform the benchmark index despite active fund management.

Index funds are primarily equity funds that invest in a particular benchmark index.

The fund manager just follows the index and invests in all the constituent shares in the same proportion as is there in the index.

Theoretically, such a fund should reflect the return of the index. That means there is no possibility of loss owing to a wrong call taken by the fund manager. Moreover, the expense ratio of such funds is lower than most actively managed funds.

Tracking Error, Expense Ratio

One of the most important factors that need to be considered before investing in an index fund is the tracking error. It is the difference in the returns of an index fund from the actual returns delivered by the benchmark index.

The tracking error measures how closely a fund follows its benchmark. The lower the tracking error, the better the fund is.

The next important factor to look at is whether the expense ratio of the fund is low or not.

It is better to select a fund that offers returns almost similar to that of the benchmark index and at the lowest possible cost.

Index Funds and ETFs

In the field of passively managed funds, apart from index funds, there is another set of funds called Exchange Traded Funds (ETFs). Though both index funds and ETFs reflect their benchmark indices, they are traded in a different manner.

Index ETFs offer better liquidity as these can be traded like shares in the secondary market.

However, there have been instances where the traded volumes of ETFs have not been sufficient to allow accurate price discovery.

As a result, investors sometimes face the possibility of selling their units at prices below the fund’s NAV or its intrinsic value.

For the savvy investor, ETFs offer greater ease in investing. However, for the novice investor, a traditional index fund may be better.

Performance

If we look at the performance of index funds over a one-year period, (as of August 23, 2012) index funds emerge clear winners against equity diversified funds.

While the average index fund delivered 8.34 per cent in the last one year, diversified equity funds delivered 5.85 per cent.

Over three- and five-year timeframes, index funds returned an annualised 5.8 per cent and 4.6 per cent, respectively. Comparatively, diversified equity funds generated higher returns of 8 per cent and 5.76 per cent on an average, compounded annually during the same time periods.

Limitations

Index funds also have their limitations. Since the fund manager does not take a call on stock selection or try to predict the movement of the equity markets, superior return is not always possible from such funds.

Actively managed diversified equity funds have proved their capability to deliver higher returns during a bull phase and similarly contain the downside when market crashes.

But since index funds merely reflect the movement of the index, one can hardly get better-than-market returns.

Index funds are ideal for those who are willing to invest in equities but don’t prefer to take much risk.

(Contributed by ICRA Online Research Desk)

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