INDEX FUNDS.. FM n FS PROJECT
Active and Passive Management
Before we get into the details of index funds, it's important to understand the two different styles of mutual-fund management: passive and active.

Most mutual funds fit under the active management category. Active management involves the art of stock picking and market timing. This means the fund manager will put his/her skills to the test trying to pick securities that will perform better than the market. Because actively managed funds require more hands-on research and because they experience a higher volume of trading, their expenses are higher.

Passively managed funds, on the other hand, do not attempt to beat the market. A passive strategy instead seeks to match the risk and return of the stock market or a segment of it. You can think of passive management as the buy-and-hold approach to money management.

Defn-
An index fund a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market condition.
An index fund is a mutual fund which merely invests in the securities in the index. It is passive, in the sense that absolutely no effort is made to produce results better than the index.

HISTORY: Index funds haven't been around forever -- how did they come about?
Long ago, there was a student at the University of Chicago who studied modern ideas of finance taught by Eugene Fama and others. After graduating, he returned to his father's company (Samsonite) and was horrified at the active management being attempted by their pension fund. He telephoned his teachers at Chicago and asked for help, and they pointed him to a fledgling quantitative finance group coming up at Wells Fargo Bank. Thus was born the first index fund, with a modest sum of $6 million.
What index did they use?
At that time, the picture had not really clarified on indexes. They started off with a "equally weighted index", which shows the returns obtained by spreading the funds equally across all the components in the index. This turns out to be an extremely clumsy index for the purpose of index funds, because every time prices move, the index fund has to trade in order to rebalance the portfolio, back to equal weights.
It was some time later that the "market capitalisation weighted" index was connected up with index funds. This turned out to be perfect in the sense that when prices changed, market capitalisations changed proportionately. Hence a fund that was locked into the index portfolio yesterday "automatically" stayed on the index portfolio today, without any need for trading. Indexing methods
[edit] Traditional indexing
Indexing is traditionally known as the practice of owning a representative collection of securities, in the same ratios as the target index. Modification of security holdings happens only when companies periodically enter or leave the target index.
[edit] Synthetic indexing
Synthetic indexing is a modern technique of using a combination of equity index futures contracts and investments in low risk bonds to replicate the performance of a similar overall investment in the equities making up the index. Although maintaining the future position has a slightly higher cost structure than traditional passive sampling, synthetic indexing can result in more favourable tax treatment, particularly for international investors who are subject to U.S. dividend withholding taxes. The bond portion can hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing.
[edit] Enhanced indexing
Enhanced indexing is a catch-all term referring to improvements to index fund management that emphasize performance, possibly using active management. Enhanced index funds employ a variety of enhancement techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies. The cost advantage of indexing could be reduced or eliminated by employing active management.
[edit] Operating indexing
Indexing Operating Performance is a method of measuring and comparing a company's performance in terms of financial metrics against the financial performance of other comparable companies (so called peers or peer universe).

Advantages:
Low costs
Because the composition of a target index is a known quantity, it costs less to run an index fund. No highly paid stock pickers or analysts are needed. Typically expense ratios of an index fund ranges from 0.15% for U.S. Large Company Indexes to 0.97% for Emerging Market Indexes. The expense ratio of the average large cap actively managed mutual fund as of 2005 is 1.36%. If a mutual fund produces 10% return before expenses, taking account of the expense ratio difference would result in an after expense return of 9.85% for the large cap index fund versus 8.64% for the actively managed large cap fund.
[edit] Simplicity
The investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly. Managing one's index fund holdings may be as easy as rebalancing every six months or every year.
[edit] Lower turnovers
Turnover refers to the selling and buying of securities by the fund manager. Selling securities in some jurisdictions may result in capital gains tax charges, which are sometimes passed on to fund investors. Because index funds are passive investments, the turnovers are lower than actively managed funds. According to a study conducted by John Bogle over a sixteen-year period, investors get to keep only 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners.[citation needed]
[edit] No style drift
Style drift occurs when actively managed mutual funds go outside of their described style (i.e. mid-cap value, large cap income, etc.) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio's diversity and subsequently increase risk. With an index fund, this drift is not possible and accurate diversification of a portfolio is increased.

Disadvantages
[edit] Possible tracking error from index
Since index funds aim to match market returns, both under- and over-performance compared to the market is considered a "tracking error". For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market.
According to The Vanguard Group, a well run S&P 500 index fund should have a tracking error of 5 basis points or less, but a Morningstar survey found an average of 38 basis points across all index funds.[5]
[edit] Cannot outperform the target index
By design, an index fund seeks to match rather than outperform the target index. Therefore, a good index fund with low tracking error will not generally outperform the index, but rather produces a rate of return similar to the index minus fund costs.
[edit] Index composition changes reduce return
Whenever an index changes, the fund is faced with the prospect of selling all the stock that has been removed from the index, and purchasing the stock that was added to the index. The S&P 500 index has a typical turnover of between 1% and 9% per year.[6]
In effect, the index, and consequently all funds tracking the index, are announcing ahead of time the trades that they are planning to make. As a result, the price of the stock that has been removed from the index tends to be driven down, and the price of stock that has been added to the index tends to be driven up, in part due to arbitrageurs, in a practice known as "index front running".[7] The index fund, however, has suffered market impact costs because they had to sell stock whose price was depressed, and buy stock whose price was inflated. These losses can be considered small, however, relative to an index fund's overall advantage gained by low costs.
Internationally, how important are index funds?
In one way or the other, around one-third of professionally run portfolios in the US are index funds. There are stock market indexes of various kinds, bond index funds, industry indexes, indexes built of low P/B companies, etc. A variety of products can be created using these indexes. Leveraged index funds, index funds that promise to juice up returns using index arbitrage, index funds which "tilt" towards specified factors, etc., are all classes of products that can be created off a core family of good indexes.
Many actively managed funds are actually heavy users of indexation in disguise: they park 80% of their money in an index, and try to juice up their returns by doing active management on the remaining 20%.
Finally, all funds, whether they use index funds or not, are subjected to performance evaluation procedures that are based on indexes. In this sense, the indexation industry is truly pervasive.

Why is all this so important? Or, what's so compelling about index funds that they should account for one-third of professionally managed funds in the US?
There are really three issues why indexation is so crucial: 1. The reason mentioned above, which is that active managers haven't been able to perform too well. Hence, passive management is the natural alternative. 2. Suppose one does want to do active management. For a large fund, it is pointless to take small positions in a few stocks based on stock picking -- this can't affect the fund NAV appreciably. And, if the fund attempts to buy large quantities of what it thinks are undervalued stocks, then the impact cost faced upon purchase generally wipes out the extra returns that are derived from the underpricing.
Hence the way forward for active management is to shift focus away from individual stocks to entire sectors of stocks. Suppose you think that the cement industry is undervalued, then buy the entire cement industry index. You could easily invest Rs.5 to Rs.10 crore at under 1% impact cost on buying the entire cement industry index over a few days. Such large positions are infeasible on individual stocks at low impact costs.
Many kinds of sectors of stocks could be used for such active management: industry indexes, a low P/E index, bond market index, etc. Active managers of the future will work by juggling their proportions of these sectors, instead of devoting effort on identifying individual stocks which are undervalued -- that is more of a retail activity better suited for people with very small funds to invest. 3. Finally, index funds have thrived because of situations where a committee invests on behalf of a constituency. An example of this is a provident fund committee which is investing the PF money on behalf of all employees.
It is extremely embarassing for the PF committee to pick an active manager who then turns out to underperform. It is much easier for the PF committee to face their constituency and say "we just picked an index fund, and the overall index went down, hence our fund value dropped".
PASSIVE WAY: That is why index funds are also referred to as passively managed funds. This is different from how actively managed funds function; they also have a benchmark index but make active stock and sector calls in their bid to outperform the index.
This is the primary difference between passive funds and active funds; one is content at giving index-linked returns, while the other consciously tries to outperform it.
In their attempt to outperform the index, active funds diverge from index funds on two important counts -- volatility and expenses. Lets take volatility first -- when active funds invest outside the index they take on stock and sector risk that are usually higher than risks associated with an index fund. This reflects by way of a higher turbulence in performance vis-à-vis index funds.
When index funds make sense Fund name | Management style | Benchmark index | Expense ratio | FIDELITY SPARTAN 500 INDEX | Index | S&P 500 | 0.10% | VANGUARD 500 INDEX FUND | Index | S&P 500 | 0.18% | FIDELITY CAPITAL APPRECIATION | Active | S&P 500 | 0.94% | VANGUARD GROWTH & INCOME | Active | S&P 500 | 0.42% |
(Data sourced from fund house websites)

When index funds do not make sense Fund name | Management style | Benchmark index | Expense ratio | FT INDIA INDEX NIFTY | Index | S&P Nifty | 1.00 | FT INDIA INDEX SENSEX | Index | BSE Sensex | 1.00 | HDFC [ Get Quote ] INDEX FUND (NIFTY) | Index | S&P Nifty | 1.50 | HDFC INDEX (SENSEX) | Index | BSE Sensex | 1.50 | HDFC INDEX (SENSEX PLUS) | Index | BSE Sensex | 1.50 | FRANKLIN BLUECHIP | Active | BSE Sensex | 1.90 | HDFC EQUITY FUND | Active | S&P CNX 500 | 2.02 |
In fact, HDFC Sensex expense ratio does not even compare favourably to HDFC Sensex Plus' expense ratio (1.50%), despite the fact that the latter has an element of active fund management to the extent of 20% of net assets.
If one looks at the index funds from the two fund houses we have selected - HDFC Mutual Fund and Franklin Templeton; at expense ratios of 1.50% and 1.00% (respectively), the disparity is too sharp, for the same fund management style. HDFC Mutual Fund's index funds are too expensive
Indian Scenario
In India, the index funds are based on the two popular indexes, NSE 50 Nifty and BSE 30 Sensex. Unfortunately, index funds in India haven’t seen the expected growth ever since their launch six years ago. The oldest index fund of UTI has delivered only 6.77% on returns since June 1998. This is primarily because of the fact that very few people in India actually invest in the index funds as investing in stocks has become a usual habit for them. Also as against the plethora of indices available in the international market, India has just two popular indices, Nifty and Sensex. This greatly restricts the options available to an Indian investor interested in investing in index funds. This has even led some to opine that probably the time for index funds is yet to arrive in India. Only the time to come will tell whether index funds are able to meet the expectations or not. TRACKING ERROR: The lack of active management generally gives the advantage of lower fees and lower taxes in taxable accounts. Of course, the fees reduce the return to the investor relative to the index. In addition it is usually impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is known as the "tracking error" or informally "jitter".
Thus the real challenge of running an index fund lies in execution. The fund manager has to strive to make sure that the fund NAV closely tracks the reported index levels. This requires considerable skill in execution. It would be extremely embarassing to report to a customer that the index has risen by 10% but the index fund NAV has only risen by 9% (from the customers point of view, this could even be owing to fraud). The error between index returns and index fund returns is called tracking error. Different index fund managers compete on promising as low a tracking error as possible.
Article in hindu business line:
IF YOU believe that the Sensex or the Nifty are about to break from the past and sail ahead of their all-time highs, investing in index funds may appear to be a tempting prospect now. But one should first consider investing in actively managed, diversified equity funds with a good long-term record.
For investors with a healthy appetite for risk (you need one to stay invested in the markets at these levels), actively managed funds such as Franklin India Bluechip Fund, Templeton India Growth Fund, HDFC Equity Fund may be among the options to consider.
Modest show: There was a significant divergence in the performance of index funds in 2003. In a surprising trend, most of the index funds which tracked the Sensex trailed those which track the Nifty by a significant margin.
This is surprising because 2003 was a year in which the Sensex, with returns of 74.5 per cent marginally outperformed the Nifty, which returned 73.8 per cent.
One explanation for the significant tracking error on the Sensex funds could be the substantial changes in the Sensex constituents this year. With the Sensex changing over to a free float index, index fund managers were probably forced to replace a significant portion of their portfolio enhancing transaction and impact costs. Within the Sensex tracking funds, Franklin Templeton Index fund, had the lowest return of 66.1 per cent, while UTI's Master Index Fund had the highest return of 76.8 per cent.
Within the Nifty funds, most funds registered a positive tracking error, notching returns that were up to 4 percentage points higher than the Nifty's returns. Here, the returns ranged from 72.9 per cent on the Nifty Benchmark exchange traded fund to 78.6 per cent on the Franklin Templeton Index Fund-Nifty plan.
Investors in the index funds which paid out dividends during the year, faced with an opportunity loss. Having pulled out part of their funds mid-way during the rally, they are likely to have earned lower returns than those who stayed invested.
Easily beaten: In 2003, as in the preceding bull markets, index funds have been beaten by the majority of actively managed funds. About 7 out of every 10 active equity funds , beat the narrow market indices such as the Sensex or Nifty.
What is more, the margin by which diversified funds have beaten the index funds is large. While the best performing index fund (tracking the Nifty or Sensex), managed a return of 78.5 per cent, the top performing equity fund (Franklin India Prima Fund), managed a return of 165 per cent. Prima Fund benefited from its mid-cap focus.
But even funds with a large-cap bias, such as the Franklin India Bluechip Fund, Templeton India Growth Fund and HDFC Equity Fund have generated return of over 100 per cent in 2003, easily outpacing the indices.
Downside protection: Index funds are usually believed to offer better protection from a downside in markets than actively managed funds. As the argument goes, if you are invested in an index fund, your downside is restricted to the fall in index levels.
But if a fund manager has aggressively picked stocks outside of the index, there is a possibility of the NAV falling much more than the index.
In the past, this has been observed in the Indian markets as well. The majority of active funds outpaced the Sensex and the Nifty in the bull market of 1999. But during the market reversal of 2000, the majority of actively managed equity funds lost more value than the indices, some losing as much as 60 per cent of their NAV. This would seem to suggest that investors seeking downside protection should switch to index funds.
But this logic may not hold good this time round. For one, some of the big losses on equity fund NAVs in 2000 were due to concentration in IT, media and telecom stocks. But most equity funds today have rigid ceilings on their stock and sector specific exposures. Equity fund portfolios thus sport a more diversified look, which may help restrict the losses in the event of a market reversal.
Second, given the sharp run-up across the range of stocks over the past year, generating returns from the current levels would seem to call for some careful stock picking. Therefore, careful stock selection may deliver better returns going forward, than passively staying with the index stocks.

In bull markets when returns are high these ratios are not as noticeable for investors; however, when bear markets come around, the higher expense ratios become more conspicuous as they are directly deducted from meager returns. For example, if the return on a mutual fund is 10% and the expense ratio is 3%, then the real return to the investor is only 7%.