Want to profit from Sensex rise? Here’s how
The BSE Sensex grew by over 30% in 2014, while some individual stocks even made double digit losses. The irony, however, is that the Sensex cannot be bought in the market like individual shares. How then can investors benefit from an appreciation in the Sensex? The answer lies in two instruments called ETFs and Index funds. Here is how they work:
1. Exchange traded funds (ETFs): An ETF is a corpus of funds created by an asset management company and invested in shares of an underlying index. For instance, if a Sensex ETF is created, the corpus will be invested in the shares of all the 50 companies that trade on the BSE Sensex, in the same proportion as their weight in the Sensex. Subsequently, the corpus would be broken down into small stock-like instruments and listed on a stock exchange. Investors can buy and sell these instruments just like ordinary shares thereon. Each of these shares represents a proportionate ownership in Sensex stocks. For this, investors have to pay only a fraction of the value of the Sensex at a given point. Since the proportion is the same, the market price of ETF shares mirrors the movement in the Sensex. This allows investors to benefit from price changes in the Sensex. Some popular Sensex ETFs are Kotak Sensex ETF Fund and SBI Sensex ETF.
2. Index funds: Index funds are essentially mutual funds that track a specific index, such as the Sensex. They raise money from their clients and put them in the 50 shares that underlie the Sensex. In return for this, they give the clients units in the fund so created. While both index funds and ETFs track the same index and come across as identical instruments, structurally they are distinct. An ETF is more akin to an ordinary equity share, which is perfectly liquid. Its price is quoted continuously and it can be bought and sold at these real-time prices. An Index fund, on the other hand is a type of mutual fund. Its units can be purchased outside the market, directly from the fund manager. Also, it has a minimum investment size, which is generally a few thousand rupees. ETFs, on the other hand are much smaller units, priced at only a few hundred rupees. Also, mutual funds cannot be bought and sold at real-time prices as real-time prices are not available for them. They can only be traded at the net asset value (NAV), which is available at the end of each trading day. Lastly, investing in mutual funds involves the payment of the asset manger’s fee. No such fee is payable for the purchase of ETFs. Only a brokerage charge, as with other shares, is applicable.
3. Benefits of ETFs and index funds: The market for both ETFs and index funds is expanding rapidly in India. For starters, this is because they allow investors to invest in indices, which is otherwise difficult to do. It would require buying all the shares that comprise the index and continuously rebalancing them to align their weights with those in the index. This is tedious and expensive because the value of the index is continuously changing. Alternatively, one could use derivatives, such as index futures and options. The risks and costs associated with these are widely documented. ETFs and index funds do the rebalancing for investors on their own. This facilitates passive investing. Further, the cost of buying one of these instruments is much lower than maintaining an index portfolio on one’s own. Derivative require a minimum investment that is very high. ETFs and mutual funds have a much smaller ticket size.