Investors in equity schemes of mutual funds have seen sharp decline in NAV in the last one year. Whereas the Sensex has fallen by 24.7% since 31^st March 2000 and S & P CNX Nifty has declined by 21.6% till date, NAV’s of large equity funds have declined sharply between 43.1% and 54.6% during the same period. The performance of the Infotech Sector funds is even worse. Most of the schemes in this category have fallen between 63% and 70% in this period.

Investors will do well to invest in index funds in such a scenario. Had the investors chosen to invest in index funds during this time they would have suffered significantly lower loss. This is because losses from the index funds were relatively lower in this period. It was observed that during the period 31^st March 2000 to 12^th March 2001 NAV’s of Index funds declined between 21.3% and 26.8% in this period (Refer Table 1). It is therefore necessary for investors to consider index fund of mutual funds as an important investment alternative.

Index fund seeks to replicate the returns generated by the benchmark index by investing in a well-diversified portfolio of equity stocks forming the index. Investment is essentially made in stocks that comprise the index in approximately the same weightage that they represented the index. The primary objective of an Index fund is to replicate the returns generated by an Index (either BSE Sensitive Index or S & P CNX Nifty or any other popular Index) subject to a tracking error.

• High Diversification: - The biggest advantage of investing in an index fund is the benefit of getting real diversification. For example the current Nifty index (widely followed benchmark by index funds) consists of 50 stocks spread across 25 sectors. Thus investors are assured of a diversified portfolio and thereby able to reduce risk.

• Low operating costs: - Index funds generally seek to follow the index passively and hence tend to have lower investment management and other expenses compared to actively managed funds. It is well known that funds with lower average operating expenses give significantly higher return over other funds with similar performance record over the long run. Thus investors are clearly benefited from lower operating expenses.
  
• Well-selected portfolio of blue chip stocks: - The composition of index consists of top blue chip stocks across a wide section of companies and sectors. The selection of the stocks for the index is done scientifically based on well-defined parameters like market capitalization, trading volumes and liquidity factors. Thus investors are able to get a portfolio of well-selected blue chip stocks.
  
• Periodic rebalancing of portfolio: -The composition of the index is changed at periodic intervals to reflect the changes in the market and economic conditions. This is also reflected in the portfolio of index funds on account of passive management of index funds. Further the portfolio is also rebalanced to reflect the changes in the market capitalization of stocks comprising the index. Thus investors are able to minimize the risk by having a portfolio of blue chip stocks comprising top performing stocks and sectors at any given point of time.

• Investment Convenience: - Investors are able to participate in the stock market and get a well diversified portfolio of leading blue chip stocks with a minimum investment. Currently it is possible for an investor to buy the index stocks by making a minimum investment of Rs2000 or Rs5000 in an index scheme of mutual fund. Whereas if investor were to actually invest in the same proportion of the index, it will require minimum investment of at least Rs1 lac. Furthermore investors do not have to worry about adjusting the portfolio according to the changes in the composition of the index.

An index fund may not able to completely mirror the performance of the index it tracks due to the tracking error. This may take place because the index is calculated on the basis of daily closing prices while the fund will be buying and selling securities at different times during the trading session. Further the inability of the fund to buy and sell exact quantities due to illiquidity in certain scrip or market conditions could also affect the performance of the fund. This is due to the reason that every net inflow and outflow has to be adjusted for the same proportion as the benchmark index. Lastly certain proportion of funds are kept in call and other money market instruments to meet the liquidity needs. This will mean variation between the performance of the schemes and its benchmark.

The study of the BSE Sensex and other investment avenues (gold, company deposits and bank deposits) over a 18 year period ended 1998 have indicated that Equity market has outperformed all other forms of investments. The BSE Sensex generated annualized return of 20.2% while company fixed deposits - the second best investment option generated annualized returns of 14.5%. Bank deposits generated marginally higher return of 9.7% compared to inflation rate of 9.2%. in the same period. (Source: Franklin Templeton Research Study)

Index funds are suitable for both kinds of investors- Investors with a short time horizon (less than a year) and long term horizon (greater than five years). When the stock prices are extremely volatile and the overall trend of index is unclear (upwards or downwards), then investors will do well to invest in index funds with a trigger option. This will mean as soon as the NAV of the benchmark index touches a predetermined target (particular figure which is lower or upper limit), he will sell all his investment in index fund. This way he can minimize the losses and maximize the gains depending on the direction of the index movement compared to sharp fluctuations in the stock prices.

Long term investors know equity markets have outperformed all other forms of investment in 86% of the times over the five year horizon. (Source: Franklin Templeton Research Study). It is well known that it is very difficult to identify a fund among a large number of funds that will demonstrate such consistent outperformance over such a long period. Thus investors are better off by investing in index fund. Investment in mutual fund over one year is subject to tax of 10% without indexation or 20% with indexation. Thus post tax returns from index fund over any other form of investment is also tax efficient.

Thus Index funds provide an ideal investment opportunity for those who want to invest in stock market but who do not have sizeable investment amount, requisite time and inclination to monitor investments on a regular basis.

Currently there are four index funds available in the market. Their details are given below: