Index Funds have gained increasing popularity in India. Before evaluating their worth as an investment tool, it is necessary to first understand what they are and how are they differentiated from an actively managed mutual fund on various parameters like cost, return, etc.

What are Index Funds?

Index funds are passively managed funds that allow investors to participate intelligently in the stock market. Let’s break this statement down so that we can understand index funds including all its intricacies.

The index is a theoretical construct: This means you can’t buy shares directly in an index, but you can buy shares of the companies which are included in the index. The most widely known index is Standard & Poor’s 500 index which is nothing but an index comprising of the largest 500 U.S. companies traded on the New York stock exchange on the basis of their market capitalization.

Index funds are passively managed. A passively managed fund is one that does not require any analysis or prediction about the performance of a particular stock on the part of the fund manager. Unlike actively managed funds where managers attempt to accurately predict the future performance of stocks on the basis of the fundamental and technical analysis, passively managed funds simply mirror an index.

It means that an index fund that tracks Nifty essentially invests its corpus in the 50 stocks that comprise Nifty, though not necessarily in the same proportion. Suppose an index comprises of only two companies with the market capitalization of company 1 being twice that of company 2, the amount that you invest in a fund that is based on this index will imply that the proportion of your ownership of company 1 will be twice that of company 2 in rupee terms.

Best Index Funds in 2017

The following are 4 top rated index funds on Groww:

ICICI Prudential Nifty Next 50 Index Fund

index fund icici prudential nifty

UTI Nifty Fund

index fund uti nifty

ICICI Prudential Nifty Index Fund

index fund icici prudential nifty

HDFC Index Fund

index funds hdfc sensex

What is ETF?

ETF or Exchange-Traded Fund is a marketable security that helps track multiple assets such as an index fund. ETFs are different from mutual funds in that they trade like common stock on the stock exchange. Also different from a Mutual Fund is the fact that it does not have a Net Asset Value (NAV) calculated at the end of every day.

Investment in index funds allows for intelligent participation in the stock market in the sense that an investor invests money according to the current trend of the market. It means that the scheme will perform in tandem with the performance of the index that it is tracking, except for a small difference known as the tracking error. Tracking error is the difference between the returns of the index fund and the benchmark index. So in practice the lower your tracking error, the better the fund’s performance. The causes of this difference are discussed later in this article.

Now that we have a basic idea as to what index funds are, let us identify investor classes for whom investing in index funds is ideal.

There are broadly two kinds of people – those who find finance fascinating and those who don’t. If you are in the latter category, index funds are a good investment option as all you need to do is invest money in an index fund and then forget about it.

Investments in index funds are likely to generate satisfactory returns for these investors and require little attention on their part. Index funds also do not require active monitoring on part of the fund manager, though it may require reconfiguring the portfolio from time to time to match the composition of the index.

Even if you do find finance fascinating, there is a major difference between interest and success. Therefore, until you acquire the right skill set and the knowledge to analyze the market which is inherently complex and volatile, investing in index funds or mutual funds is the best alternative.

Index Funds vs Mutual Funds

The factor that majorly differentiates the two is that Mutual Fund managers attempt to beat the market, that is, provide better rates of return than the index. This is in sharp contrast with Index Funds, who simply want to mirror benchmark returns.

Because mutual fund managers need to analyze and identify companies with high growth potential, they also charge higher fees than investing in index funds would cost you. Typically, an actively managed fund keeps more than two percentage points more cash than an index fund.

Index funds do not usually face heavy cash outflows during bad times, but they also do not gain heavily in good times.

Index funds fail to identify companies with high growth potential. They merely invest in companies that comprise an index, and the index generally comprises of top x number of companies by way of market capitalization. Therefore, the companies that make it to the index are already big companies and not relatively newer companies with huge potential for growth or companies that have a low free float.

Low free float means that a high number of the total shares of the company are held by its promoters and are not available to the public. The manager of an actively managed fund, however, will be able to identify and invest in such companies.

Also, particularly in the Indian context, there are only 2 indices available – Sensex comprising of 30 stocks and Nifty comprising of 50 stocks. This represents a very small subset of companies that are listed on the stock exchange. Thus, these indices may not always paint an accurate picture of the returns generated by the broader market.

The two indices, Nifty and Sensex, experience major fluctuations throughout the day, with companies constantly being dropped to make room for other companies.

Consider an example, a company that features outside the index and still manages to perform will be missed by the investor and hence is an opportunity lost. An underperforming stock while it is on the list might take up part of your investment. Unlike actively managed funds, you do not have the option to do away with such companies by removing them from your portfolio.

An index typically represents companies that have performed brilliantly in the past, with little indication as to future of the company. A company that has outperformed in recent times will find itself included in the index, but inclusion in the index is in no way indicative of the sustainability of that growth. A company that underperforms will eventually be out of the index, at which point the fund managers will want to sell their stake. It means that there are chances that the fund buys high and sells low in an index fund.

coin index

Which is Better?

Scenario in the US:

The likes of Warren Buffett and Benjamin Graham have recommended Index Funds as one of the best investments for investors who lack the skills and the time to invest on their own. The Vanguard Fund has consistently matched the performance of S&P 500 which is an index representing the biggest 500 listed companies in the US. Recent statistics show that passive funds make up about 29 percent of the U.S. market. A big reason for that has been underperformance by portfolio managers who try to beat the market but are falling short of the mark. Moody’s expects Index Funds to surpass active fund assets by2021 – 2024 in the U.S. based on the observation that investors are increasingly buying relatively cheap funds that mimic benchmarks.

Investing in Index Funds in the US is a good option as it provides returns similar to the stock exchange and does not require active involvement on part of the investors or the fund managers.

Scenario in India:

The scenario in an emerging economy like India is completely different from that in the rest of the world. This is because the equity market is at its best stage of evolution at present.

In India the concept of passive investing is still in its Infancy. The information available of different indices as well as the knowledge about these indices is fairly limited. Also, sufficient diversification does not exist on the Sensex. Sectors such as shipping, aviation, textiles and tourism have not yet been adequately explored by the Sensex. There is an absence of dynamically managed indices which makes it difficult for index funds to perform well in India.

In other countries there are innovative indices that can be taken advantage of. Even though we have indices within the stock exchange, these indices are not available for investing which limits the potential of index funds.

On an average, the gross returns of active funds have beaten returns from the Nifty total returns Index, even after taking into account the cost incurred due to investing in an actively managed portfolio. When the cost of managing the fund is factored in, the expense ratio for active funds from 2008-2017 averaged 2.32% per annum, whereas for Exchange Traded Funds it was 0.61%. This difference is more than enough to make up for the returns being provided by actively managed funds.

The mutual fund industry in India has a market capitalization of 13% as compared to the 95% in the U.S. This relatively smaller size of the mutual fund industry could be the reason fund managers are able to generate such high returns.The global scenario as explained with reference to the U.S. market is fairly different where ETFs are dominant. Because other countries have a stronger and more robust market, index funds are seen as a profitable investment in such markets. 

Another reason why mutual funds perform better in emerging markets like India is the fact that companies in India are growing at a faster pace and therefore manage to consistently offer index bearing returns. Many fund managers believe this trend could continue till the early 2020s at least.

In India, a majority of the funds outperform the benchmark index. As an example, consider this portfolio, Top 5 Mutual Funds in India. The fund largely comprises of equities of mid cap and small-cap companies. 

This fund is just one example. There are various funds like the High Risks High Returns, Wealth Creation, Long Term Wealth Creation and many other funds have consistently outperformed their respective benchmark over the long run. Their returns as compared to the benchmark are summarized in the table below:

1 YR

3 YR

5 YR

Mean

High Risk High Returns Portfolio

34.82%

18.94%

19.37%

Nifty 50

14.75%

7.86%

8.19%

Wealth Creation

32.57%

16.61%

25.13%

16.96%

Nifty 50

14.75%

7.86%

11.86%

8.19%

Long Term Wealth Creation with SIPs

23.38%

12.29%

19.41%

12.94%

Groww Equity Hybrid Benchmark

21.54%

7.57%

11.76%

8.07%

There is no denying that that cost is an important part of return on investment and a major factor to consider while making the investment decision. Though the cost of investing in an actively managed fund is higher than that of investing in a passively managed fund like an Index Fund, the extra cost is more than compensated by the higher return actively managed funds offer.

Investing in Mutual Funds also negate most of the disadvantages associated with investing in Index Funds. Procative analysis of the performance of the companies enables the fund manager to invest in funds in companies that show promising growth indications and participate more actively in the growth of the broader market.

The smaller size of the Indian mutual fund industry vis-à-vis the equity market capitalisation and lower market efficiency relative to other developed markets seem to support return generation by Indian fund managers. 

Similar to investing in index funds, the investors do not need to invest their time or effort in researching about the companies before investing in Mutual Funds, as competent fund managers will do the same for them.

Conclusion

To sum it up, though Index Funds are better suited to investors in the United States, Mutual Funds are more suitable to Indian investors as the equity market here is in its most lucrative stage and mutual funds have historically outperformed the market. It would give the investors to participate in the growth story of the Indian Market.

Investing in mutual funds is as easy as shopping online with Groww.

Happy investing!

Disclaimer: the views expressed here are those of the author. Mutual funds are subject to market risks. Please read the offer document before investing.