An Index Fund is a type of mutual fund which constructs its portfolio by tracking the composition of a standard market index such as the Nifty 50 or the Sensex. The fund, not only invests stocks which constitute the benchmark index but also in the amounts in which they are present in the index.
For example, if among the constituents of NIfty 50, Reliance Industries Limited (RIL) and Tata Consultancy Services (TCS) hold 10% and 5% weightage respectively, then the Index fund benchmarking Nifty 50 would allocate 10% of its asset to RIL and 5% of the portfolio to TCS.
The idea behind an index fund is to replicate the performance of an index in terms of returns at a minimal cost. Index funds are also called as passive funds as these do not require a high level of active management of the fund. Naturally, the expense ratio and other fees of index funds are lower than the actively managed funds, which makes them cost efficient.
List of Top Performing Index Funds to Invest in FY 2020
*Source: Value Research, Data as on Dec 11, 2019
Who Should Invest in Index Funds?
Index funds are ideally suited for investors who like to stay put with their investments for the long term. If you have a look at the historical performance of market indices, you would know for sure that they have performed well in the long run despite many instances of short term volatility.
The graph shown above shows the price movement of Sensex which had a base price of Rs. 100 in 1979. The Sensex has given over 400 times return in about 40 years with current valuations at 40,000!
Therefore, index funds are suited for investors who are looking to build long-term wealth but want to stay away from constant monitoring and juggling their mutual fund portfolio. For example, an index fund can be very much suitable for an investor who wants to build a long term retirement corpus.
Why Should you Invest in Index Funds?
- Low Cost: Since index funds are passively managed, the total expense ratio (TER) is very less as compared to the actively managed ones. While an actively managed fund may charge you anything between 1-2% as TER, an index fund would typically charge you between 0.20% to 0.50%. At face value, the cost difference may seem small but in the long run, it can become as large as 15% of your net returns!
- Diversification: An index fund typically constitutes top companies in terms of market capitalization. It means leading market players across the sectors would be a part of the benchmark index. The auto diversification allows the investor to reduce risk from staying invested in a particular stock or a sector.
- No Fund Manager’s Error Scope: Since the allocation of assets in case of index funds is not at the discretion of the fund manager, there is virtually no scope of making losses due to inefficiency in asset allocation or poor management.
- Efficient Market Hypothesis: Major economic thinkers have lent their support to the efficient market hypothesis – the theory that no fund manager or investor can outperform the market in the long run. Price anomalies are eventually discovered by competitors and stocks are priced according to their fundamental value. Hence an index fund that represents the market would outperform all active funds in the long run.
What are the Disadvantages of Investing in Index Funds?
Market Underperformance: An investor buying into this type of fund gives up the chance of beating the market by picking a good actively managed fund. The efficient market hypothesis has worked in developed economies. In the case of developing countries like India, empirical data suggest that well-managed active funds can beat the returns of passive funds such as index funds.
Mature Companies Only: Index companies tend to be mature companies who generally have their best growth years behind them. Investors in such funds do not benefit from the high growth potential of emerging small and midcap companies.
Expensive Valuations: Companies in the index have been discovered by the market. In other words, investors are buying stocks which are already expensive from a valuations perspective.
Difference Between Index Fund and ETF
An ETF or Exchange Traded Fund also tracks an index. However, ETF units are listed and traded on the stock market and cannot easily be bought from a fund house AMC (Asset Management Company) or sold to a fund house. You effectively need a demat and trading account to buy units of an ETF and you must buy them on the stock exchange.
An Index Fund, on the other hand, can be bought like any other mutual fund directly from the fund house and redeemed from the fund house. Sometimes, index funds simply hold units of the corresponding ETF of the same AMC and sometimes they directly hold the stocks included in the index.
However, there are a number of indices that are tracked by ETFs which are not tracked by Index Funds. A few examples include the Nifty Value 20 (NV 20) Index and the Nifty Low Vol 30 (Low Volatility 30).
Index investing in India
Most index funds in India track the benchmark indices – Nifty and Sensex. The Nifty Next 50 is another popular index. It is an index of the 50 largest stocks that follow the Nifty 50 stocks. The Nifty Value 20 (NV) Index is another popular index for trackers (through ETFs). The Nifty Value 20 tracks relatively undervalued stocks as measured by parameters like PE or Price to Earnings ratio, PB or Price to Book ratio, Dividend Yield and Return on Capital Employed (ROCE).
The NV 20 is tracked by ETFs like ICICI Prudential NV 20 ETF and Kotak NV 20 ETF. Other indices like the Nifty Low Vol 30 ETF are also being tracked by ETFs like ICICI Nifty Low Vol 30 ETF. The Nifty Low Vol 30 tracks stocks with relatively low volatility.
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