Over the past few months, there has been a lot of talk about Index Funds in India. And there is a good reason behind that. If you look at the one-year performance of large-cap funds, 8 of the top 10 funds in this category are index funds.
This has triggered a debate on whether the time has finally come to move to index funds or actively managed funds are still the best bet. While the final word in this debate 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?
To understand what index fund is, you first need to understand — “Index.”
In your daily lives, you must have come across news talking about how the stock markets have performed, how many points it went up or down, and the percentage change.
But have you wondered where this number comes from? Is it a change in one stock, all the stocks or something else?
The two biggest stock exchanges in India — The Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) has about 5,000 and 2,000 companies listed respectively, so it’s practically impossible for them to track the movement of each stock and then calculate the market movement
That’s where index comes into play. An index is a theoretical portfolio created in a way that it represents the overall financial market.
An index is created by first selecting the sectors and their weights and then picking companies from each of those sectors and assigning weights to each company. Which sector and what company gets chosen is basis multiple factors
For example — SENSEX is an index created by BSE and is a basket of 30 stocks from different industries. The change in the SENSEX comes from the change in the prices of these underlying stocks, and this change is used as representative of overall market movement.
Coming to the question — What is an Index fund?
Index funds are a kind of mutual fund that invests your money in the same companies and in the same proportion as the index it tracks.
How do Index funds work?
Index funds work pretty much similar to other mutual funds. They take your money and invest in the stock market. However, how they invest and manage the portfolio is what sets them apart as a category.
While fund managers of actively managed fund do extensive research to find stocks and build a unique portfolio which they believe can give superior returns, no such thing happens with index funds.
When you invest in index funds, the fund manager simply allocates the money to stocks that are part of the index and in the same proportion as the index.
Also, while in actively managed funds, the fund managers keep tweaking portfolio by selling and buying stocks regularly, index funds only remove stock if it gets removed from the index
Let us give you an example:
HDFC SENSEX Fund will buy all the 30 stocks that are part of the SENSEX and in the same proportion. Whenever a stock is removed from the index, and the new stock gets added, the fund will also replicate the change in its portfolio.
What are the advantages of investing in Index funds?
◻️ Low Fees
Index funds replicate an index; therefore, 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.
Moreover, there is no active buying and selling of stocks. All these factors make the expense of managing an index fund low, and this translates into low fees for investors.
◻️ Broad Market Exposure
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.
Investing money in the same proportion and stocks as an index makes sure you get a portfolio that is diversified across stocks and sectors. This reduces risk as all sectors or stocks seldom do down at the same time. Furthermore, you don’t miss out on any major sector thereby increasing return potential
For example, when you invest in a Nifty 50 index fund, you invest in 50 stocks spread across 13 sectors ranging from financial services to pharma.
◻️ No Bias Investing
Index funds follow an automated, rule-based investment methodology. The fund manager has a defined mandate on where the money goes and how much he/she needs to follow. This removes the human bias/discretion while taking investment decisions.
Should you invest in Index Funds?
Warren Buffet, the legendary investor, recommends US investors should choose index funds for investing via mutual funds. Moreover, the biggest mutual fund in the world is an index fund and is trusted by millions of people.
And there is a good reason for that. The combination of all the advantages mentioned above really simplifies the entire investing process. You are sure to get almost the same returns as the market is generating at a low cost and without doing much,
However, before you jump to a conclusion, a word of caution. In the Indian context, if you look at the returns of good active funds over the 5 to 10-year duration, most of them have given 3–5% more returns(alpha) than the index. But this alpha is shrinking, especially in the large-cap space and will continue to go down.
So, the smart thing would be to begin by allocating 5–10% of your portfolio to this category.