Index Funds In India: Risky Business

Index funds are a type of mutual fund or exchange-traded fund (ETF) that aims to match the performance of a specific market index, such as the Nifty 50 or Sensex. They are passively managed, meaning the fund manager does not alter the portfolio's composition but instead invests in the same securities present in the underlying index in the same proportion. This means that index funds are less volatile than actively managed equity funds, and the risks are lower.

However, there are several reasons why one might choose not to invest in index funds in India. Firstly, index funds may underperform their benchmark due to factors like trading costs, fees, and tracking errors. Secondly, index funds may experience significant short-term fluctuations that can negate investment gains, making them more suitable for long-term investors. Thirdly, compared to non-index funds, index funds have reduced flexibility in responding to price declines in index securities. Finally, there is a risk of tracking errors, where an index fund may inaccurately mirror its benchmark due to partial investment in index securities, affecting its performance.

Not suitable for short-term investors

Index funds are not suitable for short-term investors due to the following reasons:

Fluctuations in the Short Term

Index funds may experience significant short-term fluctuations that can negate investment gains, making them more suitable for long-term investors. These funds are passively managed, and fund managers do not actively make investment decisions. Hence, they are better suited to those who can stick around for the long term, allowing short-term fluctuations to average out.

Taxation

In India, taxation on index funds is similar to that of other mutual funds and depends on the holding period and fund type. Selling index fund units within a year incurs short-term capital gains taxed at the investor's income tax rate. Therefore, short-term investors may find this taxation unfavourable compared to long-term investors, who benefit from tax exemptions on long-term capital gains.

Risk and Volatility

Index funds are subject to market risks and volatility. They share similar risks with the stocks and securities in the index they follow. While index funds are generally considered less risky than actively managed funds, they can still be impacted by market fluctuations. Short-term investors may be more averse to taking on this level of risk and volatility.

Returns

Index funds may not be suitable for short-term investors seeking higher returns. Actively managed funds, which strive to beat the market, tend to perform better in the long term. Index funds, on the other hand, aim to replicate the performance of a specific market index, and their returns may be comparable to the index's returns. While index funds can match the returns of actively managed funds in the short run, they may not be able to keep up over a longer period.

Potential for underperformance

Index funds are a type of passively managed mutual fund or exchange-traded fund (ETF) designed to replicate the performance of a specific financial market index. They are a good investment option for those looking to build a long-term investment portfolio, as they offer diversification and low investment costs. However, there is a potential for underperformance in index funds, and here are some reasons why:

Index funds may experience significant short-term fluctuations that can negate investment gains, making them more suitable for long-term investors. While index funds are designed to replicate the performance of a market index, there can be a small difference between the fund's performance and the index, known as the tracking error. This tracking error can lead to potential underperformance, especially in the short term. It is important for investors to have a long-term investment horizon, usually at least seven years, to allow the fluctuations to average out and generate returns in the range of 10-12%.

Impact of Market Downturns:

Index funds can suffer losses in a bearish market, and all gains can be wiped out during a market crash. Therefore, it is recommended to switch to actively managed equity funds during a market slump. A healthy mix of index funds and actively managed funds in an equity portfolio can help mitigate this risk.

Limited Flexibility:

Index funds have less flexibility in responding to price declines in index securities. They are designed to replicate the performance of the index, and the fund manager has limited discretion to make changes to the portfolio. This lack of flexibility can lead to potential underperformance compared to actively managed funds, which can be more dynamic in their investment strategies.

Tracking Errors:

There is a risk of tracking errors, where an index fund may inaccurately mirror its benchmark index. This can occur due to partial investment in index securities or other factors such as trading costs and fees. Tracking errors can affect the fund's performance and its ability to match the index, potentially leading to underperformance.

Lower Returns Compared to Active Funds:

Active funds aim to outperform the market, while index funds aim to replicate it. Therefore, active funds can potentially generate higher returns than index funds, especially in the long term. If an investor is seeking market-beating returns, actively managed funds may be a better option.

Short-term fluctuations

Index funds are a good investment option for those who want to take a passive approach and buy and hold for five years or more. However, there are some short-term fluctuations that one should be aware of before investing in index funds.

Index funds are passively managed mutual funds that aim to replicate the performance of a specific market index, such as the Nifty 50 or Sensex. The fund manager of an index fund invests in the same stocks that make up the index in the same proportions. This means that any short-term fluctuations in the index will also be reflected in the index fund.

For example, if the Nifty 50 index experiences a sharp decline due to a market correction, the index fund tracking it will also see a similar decline. This is because the fund manager of the index fund is not actively managing the portfolio and making investment decisions. They are simply mirroring the index, which includes all the stocks in the same proportions.

Additionally, index funds may experience short-term fluctuations due to market volatility. Since index funds are passively managed, the fund manager does not have the flexibility to respond quickly to changing market conditions. This can lead to short-term fluctuations in the fund's performance, especially if the market is particularly volatile.

It is important to note that while index funds may experience short-term fluctuations, they have historically performed well over the long term. This is because the short-term fluctuations tend to average out over time, and the diversified nature of index funds helps to mitigate risks. However, investors should be aware of the potential for short-term fluctuations and ensure that they are comfortable with the associated risks before investing.

Reduced flexibility

Index funds are passively managed funds, meaning that the fund manager does not alter the composition of the portfolio. Instead, they invest in the same securities that are present in the underlying index in the same proportion. This means that the fund manager has less flexibility to respond to price declines in index securities.

Index funds are designed to replicate the performance of a particular market index, and so the fund manager cannot change the portfolio even if some particular stocks in the portfolio fare poorly. This is in contrast to actively managed funds, where the fund manager has the freedom to pick and choose stocks to invest in and can therefore respond more nimbly to market changes.

Index funds are therefore best suited to investors who are happy with market-level returns and who don't want to have to track the performance of their investments continuously. They are also a good choice for those who want to eliminate the potential bias of a fund manager.

Index funds are also less flexible in terms of investment options. They are designed to mirror the composition of a chosen index, and so the investor does not have the freedom to choose which stocks to buy or sell. This means that the investor does not need to have any financial expertise or stock selection skills, but it also means that they have less control over their portfolio.

Index funds are also less flexible in terms of time commitment. They require a long-term investment horizon of at least 7 years to be effective, as they experience fluctuations in the short term that average out over the longer term.

Tracking errors

Tracking error is the difference between the price behaviour of a position or portfolio and the price behaviour of a benchmark. In other words, it is the difference between an investment portfolio's returns and the index it mimics or tries to beat. Tracking error is reported as a standard deviation percentage difference.

Tracking error is important because it helps investors evaluate the performance of index funds and ETFs, with lower tracking errors indicating better replication of the benchmark. It is also a commonly used metric to gauge how well an investment is performing and can be used to evaluate portfolio managers.

There are several factors that can affect tracking error, including:

• Fund fees and expenses: The net asset value (NAV) of an index fund tends to be lower than its benchmark due to fees. A high expense ratio can negatively impact fund performance, but fund managers can sometimes overcome this through effective portfolio rebalancing, management of dividends or interest payments, or securities lending.
• Holdings mismatch: The extent to which a fund's holdings match those of the underlying index can impact tracking error. Funds may only hold a representative sample of the securities in the actual index, and there can be differences in weighting between a fund's assets and the assets of the index.
• Illiquid or thinly-traded securities: These can increase the chance of a tracking error, as the prices of these securities may differ significantly from the market price when the fund buys or sells them.
• Volatility: The level of volatility in the index can also affect tracking error.
• Diversification rules: Securities regulations in some countries require that ETFs not hold more than a certain percentage of their portfolios in any one stock. This can create a problem for specialised funds seeking to replicate the returns of particular industries or sectors, and can lead to a tracking error.
• Trading fees: The more a fund trades securities, the more trading fees it will accumulate, reducing returns and contributing to tracking error.

In the context of India, it is recommended that investors looking to invest in index funds should choose the fund with the lowest tracking error. Index funds in India tend to track indices such as the NSE Nifty, BSE Sensex, Nifty 50, Nifty Next 50, and Nifty Midcap 150.

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