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What are Index Funds – Should You Invest in Them?

Highlights

  • The performance of index funds is based on the performance of its corresponding benchmark
  • With no fund manager involved in it, shall you invest in it? Read the pros and cons written in this before taking a call

When you are looking to invest, there are multiple options within mutual funds. These can be equity, debt, gold, hybrid funds. Within all these categories also, there are different types of funds. There is a certain fund management strategy which is followed by each fund. These funds could be managed through an active strategy or a passive strategy. An active strategy is where a fund is managed actively i.e. frequent changes are made in the portfolio. A passive strategy is where the fund just follows or mirrors the benchmark and portfolio changes basis the changes in the benchmark. Index funds are passively managed funds, let us know more about index funds.

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What are Index Funds?

Index funds exactly mirror their benchmark and hold stocks/bonds in the same weightage as the benchmark. When there is a change in the portfolio of the benchmark, the index fund portfolio also changes accordingly.

Let us understand better with an example. There is an index fund with the name of ICICI Prudential Nifty 50 Fund. As the name suggests, this fund is benchmarked to the Nifty 50 index. The Nifty 50 index comprises the top 50 stocks listed on NSE as per market capitalization. So, this ICICI fund will have only those 50 stocks in the portfolio that are there in the Nifty 50. Also, these stocks will have the same weightage in the fund as Nifty 50. For example, if Reliance Industries is 5% of the Nifty 50 then this fund will also hold 5% worth of Reliance Industries stock. The price of all stocks keeps changing every day resulting in a change in market capitalization and weightage of the stock in the index. The portfolio of the Nifty 50 index fund also changes basis this change. Thus, the price movement of the Nifty 50 stocks whether upwards or downwards is captured by the fund daily.

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The returns from an index fund are the same as the returns from the benchmark after deducting the expense ratio. Using the same example as above if the Nifty 50 gives a 10% return in a certain period then the returns from the ICICI Prudential Nifty 50 index funds will be 10% – (expense ratio). Let us assume the expense ratio of this fund is 0.20% annualized. So, the returns for the fund will work out to be 9.80% (10%-0.20%).

Advantages of Index Funds

Expense Ratio – The expense ratio or the cost of investing in an index fund is lower than an active mutual fund, thereby adding to returns. The expense ratios in direct plans of index funds are around 0.10-0.20%. Whereas for regular plans, the ratio is 0.50-0.80%. On the other hand, expense ratios of active funds are around 0.70-1.00% in direct plans and 1.70-2.40% in regular plans.

Fund Manager Risk – There is no fund manager risk i.e. you are not dependent on a fund manager to get returns. You are investing in a fund that does not involve active fund management, hence you do not bear any losses which might arise due to a wrong call taken by the fund manager on a stock or a bunch of stocks.

Managing & Tracking – Managing index funds is easier. Rather than investing in three large-cap funds, if you just buy a single large-cap oriented index fund such as a Nifty 50 fund, that will do the job and you need not have three funds in your portfolio.

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Portfolio Churn – The portfolio of the fund changes automatically every day, stocks which are losing their weights go down and stocks which are going up their weights increase. This results in an optimum churn in the portfolio, thereby increasing the probability of better returns.

First-time Investors – These funds are a good starting point for a first-time investor who might not understand the various parameters of selecting an active fund.

Disadvantages of Index Funds

No Active Management – The lack of active fund management which is an advantage could sometimes also turn into a disadvantage. There could be times when such funds lose out to active funds who can take instant calls and have the flexibility to make changes as they wish to, thereby delivering higher returns.

Tracking Error – Though this is not a disadvantage, you should look at and monitor the tracking error of the index fund. A tracking error is an error on behalf of the fund house in having the exact portfolio as the benchmark. Due to operational inefficiencies, a fund might not be able to track the index 100%. Usually, the tracking error is negligible, but one needs to check this out. A high tracking error will defeat the purpose of investing in an index fund.

No Fund Manager’s Expertise – You do not get the benefits of the fund manager’s expertise and investment philosophy of the mutual fund since they do not have a role in the outcome or the returns from these funds, it is solely dependent on how the markets behave.

Picking Mispriced Stocks – In India, the markets are still not mature since only 2% of the population invests in mutual funds and stocks. This leads to market inefficiencies and prevents real price discovery of stock, thus giving an opportunity to fund managers to buy such stocks which are mispriced and can give outsized returns. This is even more applicable to the small and mid-cap segment. An index fund is unable to pick some of these mispriced stocks which could improve the return significantly.

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Should You Invest in Index Funds?

Index funds are a good option for someone just starting to invest in equity mutual funds. They are low cost, easy to track and less risky. We would recommend you invest in a large cap-oriented index fund such as the NIFTY 50 index fund or Sensex fund. We say so because large-cap funds can invest only in the top 100 stocks out of which the Nifty 50 index has the top 50. The portfolio of the large-cap fund is mostly similar to the Nifty 50 index fund or Sensex but expense ratio is higher by around 1-2% which means the fund manager will have to outperform by at least 2% + to do better than the index fund. This could be challenging and is evident in the returns of the last three years where index funds have outperformed most of the large-cap mutual funds.

Most of the mutual funds have index funds with names such as Nifty 50 or Sensex fund. All are the same in terms of the portfolio; you just need to check and invest in those with lower expense ratio and tracking error. When it comes to investing in small and mid-cap funds, there are small & mid-cap index funds available. But we would recommend you to invest in active funds since there is a higher probability for an active fund to outperform an index fund due to a larger universe of companies and a bottom up stock picking approach.

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