Missed the rally in India’s bellwether indices — the Sensex and the Nifty? If are looking for an opportunity to capitalise on the next run, you have two options to consider. You can either purchase units of mutual fund schemes that invest in the index’s underlying stocks, or directly buy the shares that constitute the index.

Fund houses offer index funds that invest their corpus predominantly in the equities of companies that constitute the underlying index. Index funds have the flexibility to hold some portion of the scheme’s corpus in cash if they anticipate any correction in the stock prices. Index funds offer some advantages over direct investing in equities.

First, you do not need to have a demat and a brokerage account to invest in an index fund. You can walk into the office of the respective mutual fund house or go to their website and check for online options to invest in an index fund. Alternatively, you could also buy it through a distributor, provided you are willing to shed a little more by way of expense ratio. Whereas, if you are looking to buy the share of companies that constitute the index, you will need a demat and a brokerage account.

Convenience

Second, you need not worry about changes in the index constituents or the weightage of the stocks that form part of the index. In contrast, if you invest directly in the shares of these companies, you will need to know the weightage of the respective stocks in the benchmark index. And this information may not be easily available.

Moreover, the constituents keep changing from time to time and you will need to keep a close watch on the changes and accordingly re-balance your portfolio. Also, the weightage of the stocks may change and this requires you to add or pare your exposure to these stocks. Investing in an index fund saves you the hassle of having to track the changes in the constituents and their weightage in the portfolio.

Third, tracking and measuring the performance of the index fund is much easier than that of individual stocks. You may have to measure the individual stock performance and then aggregate the performance to arrive at the return on the portfolio of stocks.

While index funds are convenient to invest and easy to track, there are some challenges, too. One, the returns of the index fund may not be the same as that of the underlying index. You can expect a marginal deviation in the returns of the fund vis-à-vis the index, given that these funds enjoy the flexibility to hold cash. This is called tracking error. These funds can hence outperform or underperform the underlying index depending on their cash calls.

Whereas, when you invest in the index stocks directly, there is no tracking error. An individual can decide whether to stay fully invested or not.

Cost

Most fund houses charge about 0.1 per cent under direct plans. However, for a regular plan, the expense ratio may be higher by 0.1-0.2 per cent. For instance, the expense ratio for ICICI Prudential Sensex Index Fund direct option is 0.1 per cent, whereas the regular option carries an expense ratio of 0.2 per cent. Likewise, the expense ratio for the direct option of HDFC Index Fund - Sensex Plan is 0.1 per cent, while the same for the regular plan is 0.3 per cent. However, when you invest in the equities of the companies that are part of an index, the only cost you’d incur is the brokerage on the purchase and sale of the shares. Also, securities transaction tax is applicable on the purchase and sale of equity shares.

Three, the key challenge when you invest in an index fund is that if the index returns are impacted due to the underperformance of one or a few stocks, as an investor, you either have to stay put with the investment or completely exit the fund. This is where direct investment in stocks that constitute the index scores. Say, for instance, if one particular stock which has significant weight in the index is not doing well, you can choose to either reduce the weightage to that particular stock or completely exit the stock. This will help outperform the underlying index.

Also, the cost in this case is the broker fee, which varies across brokers. While index funds are convenient and easy to invest in and track, it is good to weigh the pros and cons before zeroing in on an instrument.

The writer is an independent financial consultant

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