Everything you need to know about Index Funds

Index fund is the safest option for a retail investor who has little or no knowledge about the stock market. Let us understand Index Funds in detail.

Oct 18, 2019 07:10 IST India Infoline News Service

Legendary stock investor Warren Buffet is a huge proponent of index fund investing. In recent times, as equity markets continue to decline and come off their sky-high valuations, the discussion over the feasibility of index funds has started gaining traction. While the final word in this examination is yet to be said, it is important for anyone looking to invest in mutual funds to know about this category.
 
What are index funds?
As the name suggests, this is a type of fund that invests in the index (Nifty50, Sensex, sectoral indices, etc.). Its performance tends to mirror that of the index it is replicating. This means the scheme will perform in tandem with the index it is tracking, save for a small difference known as tracking error. Index funds are passively managed funds that allow investors to participate intelligently in the stock market. Index funds are passively managed funds that allow investors to participate intelligently in the stock market. Since the index fund is passively managed, the expense ratio is very low as compared to actively managed funds. Index fund is the safest option for a retail investor who has little or no knowledge about the stock market.
 
In India majority of the Index funds and ETFs primarily focus on the frontline indexes like Nifty, Nifty Next50, Nifty 100, SENSEX, etc. which are also benchmarked by large cap mutual funds. Hence, as per the SEBI mandate they are unable to invest in the mid and small cap companies. Index funds only remove stocks if are removed from the index.
 
How should you invest in index funds?
If you want to invest in an index mutual fund in India, you have two options:
  1. You can invest in Index Exchange Traded Funds (ETF)
  2. Or you can invest in open ended Index funds.
                                                               
Particulars Index ETFs Open-ended Index Funds
Procedure to invest Through a broker/brokerage house Through the website of the AMC
Demat Required Not required
Trade Can be traded on exchanges Redeemed through AMC
Pricing Possibility of discrepancy b/w market price and NAV Calculated on the basis of NAV
Tracking error Low Comparatively higher
 
A. Index ETF:  An ETF is a type of fund that owns underlying assets (shares of stock, bonds, oil futures, gold bullion, foreign currency, etc.) and divides ownership of those assets into shares. ETFs price movements mimic the movements of their underlying assets, in this case the benchmark index. ETFs pool funds from investors to invest in mix of different assets. And like stocks, they can be traded on the stock exchanges during trading hours. And they offer you the diversification of a mutual fund. However, there can be a discrepancy between the price of an ETF and its NAV as it is listed on the stock markets. Index ETFs have to be bought through brokers on the stock exchange, so you need to have a demat account to trade in them. The costs would be marginally lower than open ended index funds.  
 
B. Open-ended index funds: An opne-ended index fund is like any normal mutual fund scheme. The only difference is that the fund manager just creates a portfolio that exactly replicates an index (Sensex or Nifty). There is no element of stock selection in the index fund. The only effort the fund manager puts in here is to ensure that the tracking error is kept at the bare minimum so that the performance of the index fund mirrors the performance of the index as closely as possible. Since index funds have no liquidity of their own, they usually have a higher percentage of assets in cash and liquid securities. This leaves room for what is known as a “tracking error”. Basically, this is the difference between a portfolio's returns and the benchmark or index it was meant to mimic. Higher the tracking error, greater the deviation from actual index returns. Since index funds are not listed on the stock exchanges, they do not require demat accounts and one can directly invest in them through the AMCs website.
 
Advantages of index funds:
  • Low expense ratio: The biggest attraction of passive funds is in their low cost. Since index funds replicate an index, there is no need for a team of analysts for research and helping fund manager find stocks. Even fund managers don’t need to put their expertise in portfolio construction. Additionally, there is no need to manage the risk return balance through buying and/or selling stocks. All these factors make the expense of managing an index fund low, and this translates into low fees for investors.
  • Fund manager risk/bias eliminated: When investing in active mutual funds, there is an inherent risk that the fund manager may make an error in judgment due to certain biases or make a decision based on an emotional response. Index funds follow an automated, rule-based investment methodology. The fund manager has a defined protocol on where the money goes and how much he/she needs to follow. Thus, this risk/bias is automatically removed.
  • Broad representation & diversification: Investing money in the same stocks and weightages as an index makes sure you get a portfolio that is diversified across stocks and sectors. As the major indices are created to be representative of the overall market, they cover all the key sectors of the economy and within each sector, the relevant stocks. This reduces risk as all sectors or stocks seldom go down at the same time.
 
Disadvantages of index funds
  • Very difficult to generate alpha: Though it is difficult and very rare for a fund manager to outperform the stock market consistently, many investors and actively managed funds are able to outperform the market overall. With index funds, the potential to outperform the stock markets is negligible, as they are intended to track the market performance rather than exceed it.
  • Limited downside protection: Investing in an index fund, such as one that tracks the Nifty50, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside. Additionally, during a market correction, it is difficult to average your costs as the weightages of the underlying index have to be maintained.
  • Inability to take advantage of sudden opportunities: Sometimes obvious mis-pricing can occur in the market. For eg: the ongoing slowdown in the auto sector is a brilliant opportunity to add-up on good quality, beaten down stocks within the sector. But an index fund will not be able to exploit this opportunity to the fullest, thus leading to sub-optimal returns.
 
Should you invest in index funds?
An index fund consists of the most liquid, representative and well governed companies listed on the stock exchange. So, if the market is bullish, the fund will do well, but won't do as well as some individual performers (companies or sectors). In bad years, it won't do as bad as some individual stocks.
 
There was a recent study in the US where Warren Buffet compared returns of US index funds and funds managed by Hedge Funds. The returns of index fund were higher. But that is the case with a developed and matured market like US. In India, the story is likely to be different given that it is a growing economy, and still in a nascent stage as compared to the US. In growing economy, it's not uncommon to see mutual funds beating benchmark indices sometimes with a high margin as the market provides many opportunities to grow.
 
In US the average return of the benchmark is ~6%. So, if a fund outperforms the index by 33%, it will generate ~8% returns and post fees (of 2%), returns will be back to 6%. So, investing in passive strategy (index funds) will lead to similar returns as active investing (mutual funds). In India average market return is 12%. So, if a fund manager outperforms the index by 33%, it will lead to 16% pre-fees returns. Post fees of 2%, returns will be 14%, which is the long-term average of mutual fund returns. In this case, active investing is better than passive investing. So, mutual funds are better than index funds in a market like India, as returns on benchmark indices is higher than the US markets. So, the chances of an outperformance by mutual fund is higher in absolute terms. That is as long as one does not choose an incompetent fund manager.
 
At the same time, index funds and ETFs could be preferred during times of higher volatility and also for capturing short term market fluctuations. So, the smart thing would be to begin by allocating 5–10% of your portfolio to this category. And if you are completely risk averse, or new to stock market investing, the index funds are definitely the way to go, at least at the beginning.

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