The Economis Times, Tuesday November 07, 2006
Index funds are catching the attention of investors, as well as analysts. This is because over the past year, these funds have given higher returns than actively-managed funds in several categories. While the nature of index funds is well-known , the difference between these funds and exchange-traded funds (ETFs) is causing confusion among investors.
Index Funds
Index funds are mutual funds with a portfolio that is similar to the particular index they represent. For example , an index fund that looks at the Sensex will have the 30 shares that are present in the Sensex in the same proportion as in the latter. Hence, the performance of the index fund will mirror the performance of the Sensex. Sometimes, a rebalancing of the assets may be required so that any deviations from the actual ratio are corrected. This is a simple way to ensure that the individual’s funds are performing as well as the benchmark index that one is tracking.
Exchange-Traded Funds
ETFs possess the features of mutual funds in terms of portfolio , net asset value and other areas, but they also have the characteristics of a stock. Here, the funds can be traded during the day, based on the values that the scheme generates in the market. This means that it is not just the closing net asset value of the scheme that determines the transaction price for the individual. One can also opt for index exchange-traded funds. Here, the scheme is an index fund, but it is traded on the exchange, so it is also an ETF. This presents a better opportunity for the individual.
Clearing Confusion
Index funds are catching the attention of investors, as well as analysts. This is because over the past year, these funds have given higher returns than actively-managed funds in several categories. While the nature of index funds is well-known , the difference between these funds and exchange-traded funds (ETFs) is causing confusion among investors.
Index Funds
Index funds are mutual funds with a portfolio that is similar to the particular index they represent. For example , an index fund that looks at the Sensex will have the 30 shares that are present in the Sensex in the same proportion as in the latter. Hence, the performance of the index fund will mirror the performance of the Sensex. Sometimes, a rebalancing of the assets may be required so that any deviations from the actual ratio are corrected. This is a simple way to ensure that the individual’s funds are performing as well as the benchmark index that one is tracking.
Exchange-Traded Funds
ETFs possess the features of mutual funds in terms of portfolio , net asset value and other areas, but they also have the characteristics of a stock. Here, the funds can be traded during the day, based on the values that the scheme generates in the market. This means that it is not just the closing net asset value of the scheme that determines the transaction price for the individual. One can also opt for index exchange-traded funds. Here, the scheme is an index fund, but it is traded on the exchange, so it is also an ETF. This presents a better opportunity for the individual.
Clearing Confusion
An ETF scheme is a combination of two types of schemes. One has to first understand the basic nature of the scheme which is that the scheme is an index fund. So, the scheme has a portfolio that mirrors a particular index. The additional factor is that the ETF is traded on the exchange. Hence, investors can get the benefit of prices during the day based on intra-day changes in the index while conducting transactions . This is an added benefit as it enables individuals to buy and sell the units whenever they want during the day rather than relying on only the closing net asset value to determine the price. Another advantage of such funds is that there is no active fund management; there is only passive fund management. Hence, there is no question of selection of stocks and the weights that have to be given to each of them. Since these are index funds, the stocks are selected in the exact nature as that of the index and hence, the performance is linked to the index. Another factor that plays a part in the entire scheme of things is that the expense ratio of such schemes is comparatively lower. This helps the individual to ensure that the actual returns are not reduced by a large amount. Such funds are extremely useful when individuals are in doubt as to what will work in the market and the kind of sectors that will do well. In case of actively-managed funds, a wrong selection can result in the fund becoming a laggard in the market. It is not just the traders who use ETFs. Even some longterm investors benefit from such funds. Investors can also choose between various indices that have ETFs, which can help in diversification. For example, if an investor wants to hold an index other than the Sensex or Nifty, he can buy shares in that particular index through an ETF.
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