• Introduction
• Pros
• Cons
• Conclusion

Introduction

In our everyday conversation, we hear people saying “The market is 2% up today” or “The market is 5% down in the last 2 months”. What do they mean when they say “the market”?

The market refers to an index which is representative of the overall market. An index consists of a group of stocks and the values of these stocks determine the index value.

In India, the two main benchmark indices are the SENSEX which consists of a group of 30 stocks and the NIFTY 50, which consists of a group of 50 stocks.

An Index fund is a fund that benchmarks an Index and invests its entire corpus in the same proportion of the composition of that index. For eg. UTI Nifty Index Fund invests in Nifty 50 stocks in the same proportion as the composition of the actual Nifty 50 Index.

Investing in an Index Fund is a form of passive investing with fund manager’s job limited to replicating the Index where the composition of the index determines the fund portfolio.

Pros

Low Cost:

Since the fund replicates the index, the fund manager’s job is limited and no research team needed which reduces cost of managing an Index Fund. The expense ratio of Index Funds in India can go as low as 0.13% in India.

Vanguard, one of the largest asset managers in the world, managing about $5.1 Trillion dollars of investor money through its Index Fund products, has an expense ratio of 0.11% which saves investors billions of dollars in costs.

Good Returns:

Index Funds promise good returns over time in line with the growth in economy.

Sensex base value in 1979 was 100 and is at 35,700 in June 2018. It has compounded at a CAGR of over 16% in the last 39 years.

Nifty base value in November 1995 was 1,000 and is at 10,800 in June 2018. It has compounded at a CAGR of over 11% in the last 22 years.

Active mutual fund managers’ performance is usually judged on the basis of their performance relative to the “the markets” and relative to other mutual fund managers. In the US mutual fund industry, the Index Funds beat the managers 70-75% of the time whereas in India, the managers are outperformed by Index Funds ~45% of the time.

Easy investment strategy with diversification:

If an investor is new to investing, Indexing – as it is popularly called, is an easy strategy to implement. You get market related returns – even though your fund portfolio may rise or fall with markets, monitoring fund managers picks is avoided. Since the index is comprised of top stocks in the economy across various sectors, investors get the benefit of diversified equity fund that ensures only the blue-chip stocks get picked. As the economy grows, corporate profitability grows, the top stocks will find their place in the index and your fund investments mimics the index to deliver you best returns.

Cons

Low Flexibility:

One of the biggest drawbacks in Indexing is the inflexibility of asset allocation and investing as per the composition of the index.

However, in some markets the fund manager’s discretion works better. If the markets are volatile, then the cash allocation can be increased. But an Index Fund does have that flexibility and funds have to be invested in the index at all points of time.

Tracking error:

Tracking error is the difference in the performance of a mutual fund and the performance of the benchmark index.

A tracking error occurs in Indexing due to 3 reasons:

1. The problem with Index Funds is that you cannot directly invest in the index, but the fund manager has to physically buy the stocks to mimic the index.
2. All mutual funds hold some cash on their books. This is to help pay out investor redemptions as well as manage inflows into the fund. Usually the cash holdings are about 0.5% of the portfolio.
3. Although these are low, an Index Fund does have some expenses which causes a bit of a drag on its returns. If an Index Fund charges 0.20% in expenses and the SENSEX returns 10.00%, under a best-case scenario, the fund will only return 9.80%.

Investors should look for Index Funds that have the lowest tracking errors to maximize their returns.

Losing out on Alpha:

Investors in Index Funds lose out on the expertise of an active fund manager. In a country like India, which has a 7.1% growth rate and relatively nascent market compared to US, European and other developed Asian economies like Hong Kong, Japan, Singapore, there are more opportunities to gain an alpha. Indexing will more likely underperform the actively managed funds.

Conclusion

Indexing in India has not gained mass acceptance yet, but it is definitely something which will become more attractive to investors in the future.

And this is rightly so, because 56.60%[1] of the actively managed funds have outperformed the S&P BSE 100 over the last 5 years.

Using expert advice can help you with the best course of action for investing in an Index Fund.

[1] https://us.spindices.com/spiva/#/reports