Index Funds In India: Smart Investment Or Risky Business?

Index funds are a type of mutual fund that has gained popularity in recent years, especially after the Coronavirus pandemic. These funds are passively managed and aim to replicate the performance of a particular stock market index, such as the Nifty 50 or Sensex in India. The main objective of index funds is to track and match the returns of the underlying index, rather than aiming to outperform the market. This makes them ideal for investors who are risk-averse and seek predictable returns. In this article, we will explore the advantages and disadvantages of investing in index funds in India and provide insights into how these funds work. We will also discuss the different types of index funds available in the Indian market and offer suggestions on how to invest in them.

Simplicity of understanding

Index funds are a simple investment option for those who want to invest in India's top companies without worrying about which sector or stock will perform well. The simplicity of index funds stems from their passive nature, where the fund manager simply replicates the performance of a particular index like the Nifty 50 or Sensex. This means that the fund's portfolio will have the same stocks as the chosen index, in the same proportions. For example, if Reliance has a 10% stake in the Nifty 50 index, then 10% of your investment in an index fund tracking the Nifty 50 will be in Reliance.

The passive nature of index funds makes them a low-cost investment option. Actively managed funds, on the other hand, have higher expense ratios because fund managers and their teams of research analysts put in more work to try and beat the market. Index funds, on the other hand, do not require a fund manager to be actively involved in deciding which stocks to buy and sell. This lack of active management also removes the potential for a fund manager's personal style of investing to influence the fund's performance.

Index funds are also easy to understand because their performance is directly linked to the performance of the index they track. So, if the Nifty 50 is up by 10%, a Nifty 50 index fund will also be up by 10%. This makes it easy for investors to know what to expect from their investment. Additionally, the lack of active management means that index funds are less prone to equity-related volatility and risks.

The simplicity of index funds also lies in the fact that they are a good option for long-term investors who want to reduce the risk of losing their investment. Index funds consist of top companies whose stocks are used as benchmarks, and these companies tend to be well-established with an excellent track record. This makes index funds less susceptible to market fluctuations and provides much-needed stability.

Over the last few years, the assets under management (AUM) of index funds in India have increased significantly, indicating that more and more investors are attracted to the simplicity and low-cost nature of these funds.

Low expense ratio

Index funds are passively managed funds that aim to track and replicate the performance of a stock market index. They are not actively managed and do not aim to outperform the market. Due to their passive nature, index funds have a low expense ratio.

The expense ratio of a fund covers the costs of managing the fund, including management fees and operating fees. Index funds require less portfolio management and active trading, which minimises their operating fees. This makes them a cost-effective option for investors.

Index funds are ideal for investors who are risk-averse and seek predictable returns. They are also suitable for those who want to invest in a diverse range of stocks or bonds but do not want to actively pick securities or time the market.

The low expense ratio of index funds is advantageous for long-term investors who want to track indexes and gain exposure to specific market segments over time. The low expense ratio also contributes to the overall low cost of investing in index funds, making them accessible to a wider range of investors.

In India, index funds have gained popularity due to their simplicity, low-cost structure, and the underperformance of some active fund categories. As of March 2020, there were more than 110 passive funds in India, with assets under management (AUM) crossing Rs 2 lakh crores.

When choosing between passive fund investments and active fund managers, investors should consider the expense ratio as a key factor. Index funds with low expense ratios can provide higher returns on investment compared to similar funds with higher expense ratios.

Overall, the low expense ratio of index funds makes them an attractive option for investors seeking a cost-effective way to gain exposure to the market and diversify their portfolios.

Less managerial influence

Index funds are passively managed, meaning they aim to replicate the performance of a particular index, such as the Nifty 50 or Sensex. This means that the fund manager does not need to actively select stocks or have a separate team of research analysts, resulting in lower operating expenses and expense ratios. This passive management style also leads to less managerial influence, as the fund simply follows the movement of the chosen index. The manager does not need to choose which stocks to invest in, reducing the potential for their personal investing style to impact the fund's performance.

Index funds in India have gained popularity due to their simplicity, low-cost structure, and the underperformance of active funds in recent years. While the passive fund market in India is still in its early stages compared to developed countries like the US, it has experienced exponential growth in recent years, with assets under management (AUM) increasing from ₹5,000 crore to ₹2 lakh crore in the last five years.

The lack of active management in index funds means that investors must wait for index changes to exit a stock, which may be too late in some cases. However, as a stock's performance declines, its impact on the index also decreases, reducing its significance in the fund's portfolio. Overall, index funds offer a simple, low-cost investment strategy that allows the market to be the fund manager.

Diversification

Index funds are a great way to diversify your portfolio. When you purchase shares of an index fund, you are exposed to all the stocks in a particular index, which could be a general market index like the S&P 500 or a sector-specific index like oil, technology, or finance. This means that if one stock is depreciating, the others will make up for it. Index funds are also a great way to get exposure to a wide range of securities without having to buy each stock individually, which would be costly and time-consuming.

Index funds are passively managed, meaning they don't require extensive tracking or active stock selection and market timing. This passive management strategy also results in lower operating expenses and transaction costs compared to actively managed funds. Index funds have a low turnover of securities, which leads to lower transaction costs and tax efficiency as capital gains are minimised.

The performance of index funds closely replicates the performance of active funds without the fees or tracking errors. As a result, investors can expect returns that match the broader market over the long term. For example, if the Nifty 50 index increases by 10% over a certain period, the Nifty 50 index fund would aim to deliver a similar return to its investors, minus any fees or expenses.

Index funds are ideal for investors who are risk-averse and expect predictable returns. They are also suitable for those with a long-term investment horizon, usually more than seven years, as the fund experiences many fluctuations in the short run that average out over time.

In India, passive investing is largely limited to market cap-based factors, with a small number of passives based on other factors like quality and volatility. However, there has been exponential growth in passive funds in recent years, with more than 110 passive funds and Assets Under Management (AUM) crossing Rs 2 lakh crores as of March 2020.

Long-term investment

Index funds are a great option for long-term investors. Here are some reasons why you should consider investing in index funds in India for the long term:

Diversification and Risk Management:

Index funds offer diversification by investing in a basket of different stocks and securities. This lowers the risk of having all your eggs in one basket. Additionally, index funds are less prone to equity-related volatility and risks since they map an index. This makes them a good option for investors who want to reduce their risk exposure.

Low Costs and Expenses:

Index funds have a lower expense ratio compared to actively managed funds. Since they are passively managed, there is no need for a separate team of research analysts, which reduces costs. The expense ratio of a plain vanilla Nifty fund is between 5-10 basis points, while actively managed equity funds typically have higher expense ratios of 1-1.25%. Over time, these cost savings can add up to significant amounts.

Simplicity and Ease of Understanding:

Index funds are easy to understand as they simply replicate the performance of a particular index. This simplicity has attracted many investors, especially those who want exposure to India's top companies without having to pick specific sectors or stocks.

Long-Term Performance:

Index funds have performed well over the long term. For example, the Nifty has generated an 11-fold return (10.3% CAGR) since its inception in 1995. This consistency makes them attractive for long-term investors.

Reduced Managerial Bias:

Index funds follow the movement of a particular index, so the fund manager's style and preferences do not impact the investment decisions. This eliminates any potential bias and ensures that the fund's performance aligns closely with the underlying index.

Structural Tailwinds:

Investing in thematic index funds can provide exposure to promising themes like healthcare, consumption, and financial services, which have structural tailwinds in the long run. These sectors are expected to perform well over the long term due to factors such as rising healthcare awareness and the introduction of new treatments.

Global Exposure:

Some thematic index funds also provide global exposure, which can be beneficial for sectors like healthcare, where markets such as the US drive a lot of research and spending. Index funds can provide access to international stocks and markets without the need for deep research and expertise.

Suitable for Risk-Averse Investors:

Index funds are ideal for investors who are risk-averse and seek predictable returns. They offer stable returns that match the performance of the underlying index, making them less susceptible to market fluctuations.

Tax Efficiency:

In India, long-term capital gains from index funds are tax-exempt up to a certain limit. This makes them a tax-efficient investment option for long-term investors.

When considering index funds for long-term investment, it is important to remember that they are not meant to outperform the market but rather to mirror the performance of the underlying index. Additionally, while index funds have performed well historically, past performance does not guarantee future results. It is always important to carefully consider your investment goals, risk tolerance, and time horizon before making any investment decisions.

Frequently asked questions