- Date : 03/01/2022
- Read: 7 mins
In the last couple of years, active fund managers have been finding it difficult to beat their benchmark, specifically in the large-cap fund space. So, many investors prefer to invest in low-cost index funds rather than active funds. This article focuses on what index funds are, how they work, how to invest in them, things to know before investing in them, etc.
There are two approaches to investing in a mutual fund: active and passive. In an actively managed fund, the fund manager decides which stock to buy, how much to buy, and when to buy. At the time of selling, the fund manager again decides which stock to sell, how much to sell, and when to sell. However, a fund manager has no say on such transactions in a passively managed fund. A passive fund mirrors a benchmark index. Passive investing can be done through an Exchange Traded Fund (ETF) or index fund. This article will focus on index funds and discuss what you need to know about them.
What are index funds?
An index fund invests in all the benchmark constituents, such as the Nifty 50 or Sensex 30. As per SEBI rules, an index fund has to invest a minimum of 95% of its total assets in the securities of an index that it is tracking/replicating. An index fund is an open-ended mutual fund scheme tracking/replicating a particular index. The objective of an index fund is to track an underlying index and replicate its returns. An index fund doesn't aim to outperform the underlying index.
How does an index fund work?
An index fund invests its money in all the benchmark index constituents as per their weightage in the benchmark index. For example, the SBI Nifty Index Fund has Nifty 50 as the benchmark. In this case, it will invest in all the Nifty 50 stocks in the same proportion as their weightage in the Nifty 50 Index.
For example, as of 29 October 2021, the weightage of the top Nifty 50 constituents was as follows:
The SBI Nifty Index Fund will invest the money received from investors in the above Nifty constituents as per their weightage in the Nifty 50 Index. So, out of every Rs 100 received from investors, Rs 10.70 will get invested in shares of Reliance Industries Ltd., Rs 9.03 will get invested in shares of HDFC Bank Ltd., Rs 8.07 will be invested in shares of Infosys Ltd., and so on.
The SBI Nifty Index Fund will track the performance of the Nifty 50 Index and replicate its performance. The fund will mirror the returns of the Nifty 50 Index with some variation. The variation is due to expense ratio and tracking error. We will understand these two terms in the next section.
Things to consider before investing in an index fund
When two index funds track the same underlying index like the Nifty 50 Index, their returns can still be different. It happens mainly due to the two parameters - expense ratio and tracking error. Let us understand these two important parameters that you should consider before investing in an index fund.
a) Expense ratio: An index fund, just like any other mutual fund scheme, has to incur various expenses for running the fund. These expenses are charged to the fund in the form of an expense ratio. The general rule is: the lower the expense ratio, the better. So, you should choose an index fund with a lower expense ratio.
b) Tracking error: The role of an index fund is to mirror the performance of the underlying index, such as Nifty 50. However, a fund manager does not invest 100% of the money collected from investors. Some money is kept aside to meet redemptions and other expenses of the scheme. It leads to a small difference in the returns of the underlying index and the index fund. This difference in returns is known as the tracking error. The general rule is: the lower the tracking error, the better. So, you should choose an index fund with a lower tracking error. You can check the tracking error of a particular index fund either on the AMC website or other third-party websites such as www.mutualfundindia.com.
For an investor, an ideal index fund will be one with a combination of the lowest expense ratio and lowest tracking error.
List of index funds available for investors
Various indices launched by the National Stock Exchange (NSE) include Nifty 50, Nifty Next 50, Midcap 150, Smallcap 250 indices, etc. The NSE keeps launching new indices from time to time. Mutual fund houses launch various index funds based on these underlying indices from time to time. Listed below are some of the existing index funds based on these indices that are available for investors.
Table: List of equity index funds based on Nifty indices
How to invest in an index fund?
To invest in an index fund, as an investor, you need to take the following steps:
1) Decide which kind of stocks (and accordingly which index) you wish to invest in. Your options include:
- Large-cap stocks: Nifty 50 and Nifty Next 50 indices
- Mid-cap stocks: Nifty Midcap 150 Index
- Small-cap stocks: Nifty Smallcap 250 Index
- Stocks across market capitalisation: Nifty 500 Index (includes all constituents from Nifty 50, Nifty Next 50, Nifty Midcap 150, and Nifty Smallcap 250 indices)
2) Once you decide the kind of stocks and, accordingly, the index you wish to invest in, you need to find the various AMCs offering index funds based on that particular index.
3) Compare the index funds (based on the same underlying index) of various AMCs on parameters such as expense ratio, tracking error, etc.
4) Once you finalise the AMC and the particular index fund, you can proceed with investing in it.
5) You can either invest a lump sum amount or start a systematic investment plan (SIP). Ideally, it is recommended that you invest through the SIP mode. You can invest directly through AMC's website or the website/app of various fintechs such as Zerodha, Groww, Glide Invest, etc. <Add link- best apps to buy direct Mutual funds>
Growth of passive investing in India
Over the past few years, many people have started investing in passive funds (index funds and ETFs). As a result, the passive fund assets under management (AUM) have seen massive growth in the last decade.
Table: Growth of passive investing in the last decade
As seen in the above table, the passive funds' AUM was only Rs 2547 crore in March 2010. As of September 2021, the passive funds' AUM has grown exponentially to Rs 4,13,097 crore. In March 2010, passive funds AUM was just 1% of the overall MF industry AUM. As of September 2021, the passive funds' AUM forms 11% of the overall MF industry AUM. In the coming years, the share of passive funds is expected to grow rapidly and form a significant share of the overall MF industry AUM.
Cons of investing in index funds
While index funds have various advantages, they do have some drawbacks that you should be aware of. Some of these include:
a) No alpha generation: The role of an index fund is to replicate the performance of an underlying index and not to generate alpha over it. So, by investing in index funds, investors can’t expect any alpha or additional returns over the underlying index.
b) Lack of flexibility for the fund manager: An index fund manager has to invest in all the index constituents in the same proportion as their weightage in the index. So, an index fund manager does not have any flexibility - unlike an active fund manager who can choose which stocks to buy, when to buy, how much to buy, and at what price to buy.
c) Lack of risk management: An index fund manager cannot avoid specific stocks or sectors based on factors like market cycle or performance of the company. An active fund manager can do this and avoid risks that can impact the returns of the scheme unitholders. However, an index fund will continue to hold such stocks that are performing poorly or going through a negative market downturn. It increases the risk for the index fund unitholders and impacts their returns.
With markets becoming more and more efficient over time, it will become increasingly difficult for active fund managers to beat the underlying index and generate superior returns. In such a scenario, more and more investors will prefer to invest in low-cost index funds rather than invest in active funds with a high expense ratio. It will lead to index funds gaining more market share in the future.