Buying the Index Approach

Buying the Index Approach

Buying the index approach is a popular investment strategy in portfolio management where an investor purchases a diverse range of securities that match the composition of a particular stock market index. In this approach, an investor buys shares in a fund or an exchange-traded fund (ETF) that tracks the performance of a benchmark index like the S&P 500 or the Dow Jones Industrial Average. By investing in the index, the investor is essentially investing in the entire market, rather than just a few individual stocks.

The advantage of buying the index approach is that it provides broad market exposure and diversification, reducing the risk of underperforming the market. This approach also eliminates the need to pick individual stocks, which can be a daunting task for many investors. Additionally, buying the index approach tends to be cost-effective because index funds typically have low fees compared to actively managed funds.

However, the buying the index approach has some limitations. While it offers broad market exposure, it also means that an investor cannot benefit from individual stocks that outperform the market. Moreover, the index composition may not always align with an investor’s financial goals, risk tolerance, or values. Overall, buying the index approach can be an effective investment strategy for investors who seek broad market exposure, lower fees, and a simpler approach to portfolio management.

Buying the Index Approach evaluates the performance of a portfolio based only on the rate of return. It does not consider risk. The approach assumes that all assets of the fund at the beginning of the period of review and all cash flows during the period are invested in the “units” of the suitable market index (NSE Nifty) to form a notional fund. Investment income received by the notional fund is also reinvested in the index units. Expenses involved in investing initial cash balances, cash flow, and investment incomes are taken into account.

At the end of the period of review, the total number of units held in the notional fund is multiplied by the index number to get the monetary value of the notional fund. Next, this is compared with the value of the actual fund at the end of the period to see whether the manager has created value over and above the passive alternative of performing in line with the index.

Example

On 30 April, 2009 the market value of a portfolio was at Rs. 10,000. On 31 March, 2010, the value of the portfolio was at 12,500.

The portfolio’s cash flow and investment income.

Month	Cash Flow	Investment Income
Apr	100	25
May	120	20
Jun	80	15
Jul	20	10
Aug	35	24
Sep	28	14
Oct	100	15
Nov	150	45
Dec	90	30
Jan	88	35
Feb	90	40
Mar	88	35

Market Index Values

Date	Index Value
01 Apr 2009	4400
30 Apr 2009	4500
31 May 2009	5200
30 Jun 2009	4800
31 Jul 2009	5500
31 Aug 2009	5800
30 Sep 2009	5900
31 Oct 2009	5800
30 Nov 2009	5400
31 Dec 2009	5600
31 Jan 2010	5800
29 Feb 2010	6000
31 Mar 2010	4800

The number of units held in the notional fund as on 1 Apr 2009:

10000/4400 = 2.27273 units.

The additional number of units purchased by investing the cash flows and reinvesting the investment income into the notional fund will be as follows.

Month	Total Invested	Index Value +1%	Add. Units Purchased   (Total invested/index value)
Apr	125	4545	0.02750
May	140	5252	0.02666
Jun	95	4848	0.01960
Jul	30	5555	0.00540
Aug	59	5858	0.01010
Sep	42	5959	0.00705
Oct	115	5858	0.01963
Nov	195	5454	0.03575
Dec	120	5656	0.02122
Jan	123	5858	0.02010
Feb	130	6060	0.02145
Mar	123	4848	0.02537
Total Units			0.23983

The number of units held as on 31 Mar, 2010.

2.27273 + 0.23983 = 2.51256 units

Value of the notional fund as on 31 Mar, 2010:

2.51256 x 4800 = 12060.288

Difference in capital appreciation:

Notional fund value – Index fund value

12500 – 12060.288

= Rs. 439.71

With this, it is observed that the manager has added value to the portfolio beyond the passive strategy of holding the index. The performance would have been seen as negative if the value was negative.