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Managing index funds

A lower expense limit is necessary for index funds because of the way they are constructed and managed, writes Arnav Pandya.

india Updated: Dec 30, 2007 22:28 IST
Arnav Pandya

Mutual funds schemes have a cap on the total expenses that they are allowed make. This gives protection to the investors in the form of a certain amount being charged to their holdings.

The cap limit is present with respect to both equity-oriented schemes and debt oriented schemes due to the different natures of both schemes. There is a need to look at a separate category of schemes, which are index funds in a different light.

Index funds are funds that mimic the portfolio of an index. They are constructed in such a manner that the portfolio of the scheme will be similar to the portfolio of the index.

Lower expenses are a must for index funds. The way in which they are constructed and managed shows very clearly that a lower expense limit is necessary.

Once the initial portfolio is constructed then there is no active management in the portfolio.

This means that the fund manager will not select and change the scrips that the fund will invest in and hence there is no research and other work to be done as far as the construction of the portfolio of the schemes are concerned.

The movement of the portfolio will be in tune with the movement of the index and hence the returns of the scheme will track the returns of the index on which this is constructed. At certain intervals of time there will be a specific rebalancing of the portfolio and hence at this point the portfolio will once again be brought in exact level of the index if there has been some slight variation due to various events.

Due to this reason there is little work in managing the index mutual funds and the investor should expect a lower amount of expense related to these schemes.

For equity oriented schemes the expense allowed depends upon the size of the assets in the scheme and there are restrictions on the amount that will be charged to the scheme.

The limit for index schemes has been kept at 1.5 per cent, which is good news for investors as they are sure in the knowledge that the expenses will not increase above a certain limit. This figure will be lower than the one seen for diversified equity schemes and due to this reason there is an element of ease for the investors as the cost for them will not go proportionately high.

It would be even better if schemes are able to show an expense level that is even lower than the maximum limit set because then investors will be getting a larger amount of bang for their buck. There is a direct relationship for the investors and the returns that they earn because the expenses are adjusted in the net asset value of the fund. In developed countries the expenses of such funds are extremely low and this also increases their popularity with investors.

The writer is a certified financial planner