What are Index Funds and how do we select them?
Index Funds are the best option for most of the investors
Index funds are a category of mutual fund using a passive investing approach. It’s where a fund manager will buy all the stocks in the index (like Sensex, Nifty, Nasdaq, etc.) in the same proportion as they are in that index. While in active investing the fund manager has the discretion to buy stocks that she thinks are best suited for the fund. Diversified equity funds are examples of active funds. An index fund purely invests its money in the constituents of an index. It is only when the stocks are added or deleted from the index that the index fund manager needs to make any changes to the fund portfolio. The idea behind an index fund is to replicate the index returns as close as possible.
Index funds were made popular by John Bogle, founder of the Vanguard Funds in US. He created index funds almost 45 years ago as a way for everyday investors to compete with the professional investors. He explained his perspective in the book Bogle on Mutual Funds. Index Funds are quite popular in developed countries where it is difficult to beat the stock market returns and slowly, they are becoming popular in India as well.
Index funds have become a major source of investment among investors who seek passive index strategies as opposed to active fund management. Rather than picking stocks your fund manager thinks will out-perform the market, you own all of the stocks in a certain market index.
The main benefits are:
Low Cost
Investing in index mutual funds can be an excellent low-cost strategy for the whole or a part of our portfolio. On an average, index funds only charge 0.10% per annum expense fees whereas diversified mutual funds charge between 2% - 3% per annum as expense fees. Over a long period of time, this low cost becomes a huge advantage for the investor and ends up beating most of the diversified funds.
Less Trading
Index funds also typically make trades less often than active funds, which leads to fewer fees and lower taxes and thus better returns.
Diversification
Index funds use diversification where they spread our investments across different types of securities in order to balance out and mitigate the risk for an investor. When we buy an index fund, we are exposed to many different kinds of stocks in the market. If one or two stocks provide negative surprises, the other stock balance out the risk with better returns.
Good Returns Over Long term
The index funds can provide good returns over a longer term (more than five years). But this doesn't mean that there cannot be short term gain as well. The Sensex has more than doubled since its March 2020 lows and so have all the index funds in only 18 months. But this kind of return are the exception, not the norm.
A few disadvantages:
Tracking Error
Index are vulnerable to the risk of tracking error. Tracking error is the extent to which the index fund does not track the index, which is very minimal in most of the cases. This error may occur in an index fund due to corporate actions, index constituent changes, liquidity provisions for redemption, etc. The tracking error is quite low over the long run.
Returns can be volatile
We have to remember that index funds don't ensure investment success. They will provide a return very close to the benchmark index. So, if the Sensex/Nifty is going down so will the value of the index fund in our portfolio and vice-versa.
There are some factors we need to consider before buying Index Funds:
Risk – With consistent returns over long periods of time, the risk associated with index funds is quite low. However, it’s a good practice to have a mix of index funds and bond funds as this helps us to stay afloat during market declines.
Returns – Returns from index funds are almost the same as that of the market index. Tracking errors indicate the difference in the performance of the index fund against a set benchmark (Sensex, Nifty, etc.)
Expense Ratio – An expense ratio is a percentage of the total assets of the fund charged by the mutual fund company for their services. The lower the expense ratio, the better for us.
Tax – Since index funds are equity funds, it is important to remember that they are subject to taxes – long-term capital gain tax or short-term capital gain tax, depending upon when they are bought and sold.
Invest based on your goals – Index funds perform better over a longer period of time so it is advisable to invest for a minimum of 5-7 years. This allows us to get the maximum returns as per the market index.
Below, we can see the returns of the major index funds that we have in India.
Conclusion
For the individual investor looking to build wealth for the long term, the low-cost index funds are one of the best investment options. These are also best for the people who want to spend less amount of time in doing their investments.
As one of the great investors, Warren Buffett says, "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”