When it comes to investing in the stock market, investors are faced with many confusing choices - which stock to buy or which fund to invest in? Often, the number of choices and the varying degrees of success that investors have had with each of these investment options becomes overwhelming. This is especially true if the stock you buy is going through a rough patch or the mutual fund you invested in is underperforming the market.
Index funds are a type of mutual fund that can help solve this problem. These funds invest in stocks that mirror a stock market index, such as the Nifty 50 or the Sensex. These are passively managed funds, which means that the fund manager invests in the same securities and in the same proportions as those in the underlying index. Their mandate is to 'match' the index as closely as possible, so investors can earn almost precisely the returns from the index.
Below are some of the key advantages of index funds:
Index funds offer a lower-cost method of investing due to their lower expense ratios, especially when compared with actively managed funds. This is because passive funds do not involve any specific tactical investment calls, fund manager analysis, or investment strategies. Over time, the savings from having a lower expense ratio can compound into a considerable sum.
Index funds are easy to invest in - one does not need in-depth knowledge of stock picking to invest in them.
Their portfolios are completely transparent. You will always know what is inside the portfolio and how much of each stock is there, since fund managers do not play an active role in decision making.
While discussing advantages, let's also discuss a few disadvantages:
Let's understand an Index first. Think of an index as a sort of virtual portfolio created by the stock exchanges. Just like the term suggests, it is simply a basket of securities or other financial instruments representing and measuring the performance of a specific sector, asset class, market or strategy.
For example, when you buy a Nifty 50 Index Fund, you are essentially buying stocks of the 50 largest companies in India by size, listed on the NSE. Now, the value of these companies (by market capitalization) is more than 60% of the thousands of companies listed on the stock exchange, as on September 30, 2022. So, if you were to invest in this index, you will now get exposure to the biggest Indian companies at once. With such a decision, you get in-built diversification and don't have to worry about individual company failures. Even if there is one, the exchanges remove such a company from the index (because the company will likely drop out of the list of top companies) and replace it with a different one.
But why do you need an index fund? Can you not simply construct the exact same portfolio yourself without the need for a fund manager or an AMC? Well, you cannot directly buy the Sensex or the Nifty 50- the exchanges don't offer a product like this directly. And if you tried to construct the same portfolio yourself, it will be very difficult. For instance, as of October 31, 2022, Reliance Industries forms 11% of Nifty 50. If you had Rs 2 lakh to invest, you would have to invest Rs 22,000 in Reliance by buying exactly 8.48 shares at Rs 2,592 (the price as of this writing). Which will not even be possible. And then modify this % by buying & selling 50 different securities on a real time, daily basis. Go figure!
Fortunately, Index funds make this simple for you.
Index funds take a market index as a benchmark and aim to match or track it as closely as possible. The composition of such funds is adjusted periodically whenever the target index constituents change. These funds don't require expert fund managers or analysts to operate. On the contrary, active funds aim to beat the chosen benchmark and try to deliver better returns than it does. Active funds are managed by a team of experienced portfolio managers and analysts who study specific stocks, sectors and/ or the market as a whole and try to determine the best time to buy and sell various stocks to get the maximum returns possible within a defined level of risk. Such funds, therefore, involve active interventions and, consequently, higher costs.
There are many types of Index funds. Here are some of them:
Broad Market-Based Index Funds
These try to replicate a large segment or a wide range of the market. They invest in stocks across different sectors and market capitalisations and hence tend to portray the total performance of the stock market. A Nifty 500 based index fund is an example of this type.
Market Capitalization-Based Index Funds
A market capitalization-based index fund gives higher weightage to stocks with a higher market capitalization. Indices such as Sensex or Nifty 50 are market-cap weighted.
Equal Weight Index Funds
In an equal-weighted index fund, every stock in the Index will have the same weight. For instance, if the underlying Index is Nifty 50, all the 50 companies in the corresponding equal-weight Index fund will have an equal weightage at approx. 2%.
International Index Funds
These index funds offer investing opportunities in stocks of companies listed outside of India, providing investors exposure to global markets. These can track multiple US-specific indices like S&P 500, NASDAQ, NYSE FANG+ Index, among others.
Factor-Based or Smart beta Index Funds
These are a type of index funds that apply certain filters or selection criteria (known as factors) on top of an underlying index to try to outperform the vanilla underlying index by attempting to filter the better companies from the worse ones.
Debt Index Funds
A debt index fund is based on an index comprising only corporate debt securities or government debt securities- meant for those whose goal is less to do with growing wealth but more to do with beating bank savings or deposit rates and earning more tax-efficient returns.
The primary difference between an index fund and an exchange-traded fund (ETF) is that ETFs can be bought and sold at any time during the day, like a company's share, while index funds can only be traded at a set price (NAV) at the end of the trading day.
ETFs typically track a particular index, sector, commodity, or other assets, just like index funds. They can be structured to track anything from the price of an individual commodity (such as gold) to a large and diverse collection of securities, or even specific investment strategies. Investors need to have a demat account to trade in an ETF, while index funds are regular mutual funds that can be invested in directly with the fund company. Therefore, demat accounts are not needed to invest in index mutual funds.
Investing in an index fund may seem straightforward as all similarly themed index funds in the market are likely to give you the same returns. However, there are two key factors you need to keep in mind when selecting an index fund.
Expense Ratio: The lower the expense ratio (the cost of managing the fund from the asset management company's standpoint), the less the reduction from the returns earned by the portfolio. Therefore, all other things being equal, choose a fund with a lower expense ratio.
Tracking Error: The lower the tracking error (the deviation between the returns from the fund and the returns from its benchmark index, measured over different periods of time), the better it is for you. All other things being equal, choose a fund with a lower tracking error. It's worth noting that the higher the expense ratio, the more likely the fund will have a tracking error.
Investors around the world and in India have realized that they are a sensible, no-nonsense, nobias choice that encourages staying in the market and helps avoid excessive decision-making that could hurt investment outcomes.
Experts are recommending them more frequently, and cost-sensitive investors are realizing that index funds have all it takes to form a solid core for a portfolio, rather than playing a peripheral role. This is reflected in the nearly 16-fold jump in assets under management in index funds in India between September 2019 and September 2022, from Rs 6,572 crore to INR 104,994 crore, according to data from the Association of Mutual Funds in India (AMFI).