This is not a discussion on the merits of investing in mutual funds versus that of investing directly in individual stocks.
This discussion is about the benefit of investing in Index Funds over investment in other, more specific or targeted funds.
An Index Fund is a Mutual Fund that tries to mirror the composition of a stock market index. It is based on the assumption that the requisite due diligence has been done while selecting the stocks that will comprise the index, including the weightage of the stocks, and that further efforts in improving it might only result in marginal games that may not even offset the higher cost of the effort. The major effort is in keeping the fund aligned with the index as they change either the composition or weightage of stocks.
This way, index funds are able to engage in ‘passive’ investing at a lower cost than ‘active’ funds, with the benefits being passed on to, or shared with, their investors. This leads to the fund generating a return that is almost identical to the returns generated by the index.
Benefits of investing in index funds
There are several benefits for individuals:
Portfolio selected by experts
The goal of every fund is to deliver the best returns, within the flexibility allowed by its mandate. Much of the effort of fund managers is towards research in the target securities, for the same purpose, delivering the best returns.
With an index fund, the portfolio comes pre-selected, that too by a team of experts appointed by the exchange to determine the composition of its index, or the different indices that it might be monitoring. Whether it is the BSE Sensex, the NSE Nifty50 or any other index, the composition is a process that involves scientific techniques, including back-testing.
The investor can either mirror the chosen index through stock selection on his/ her own, or simply invest the money with a mutual fund that does the same. In both cases, the return will closely mirror the return delivered by the stocks in the index. Doing it individually will deliver a marginally better return, but with the added effort of tracking and making changes from time to time.
Lower cost
On account if its nature as a ‘passive’ investment, fund managers do not have to invest much time or effort in researching. This lower cost translates into higher returns for investors.
The following comparison between two funds of the same company, one index based and the other equity growth based, illustrates:
|
Fund Name
|
Expense Ratio
|
|---|---|
|
SBI Nifty Index Fund Direct Growth
|
0.18%
|
|
SBI Long Term Equity Fund Direct Growth
|
1.07%
|
|
HDFC Nifty 100 Index Fund Direct Growth
|
0.30%
|
|
HDFC Large and Midcap Fund Direct Growth
|
1.06%
|
Diversification
Diversification is an integral strategy in most investing decisions. Investment in an index fund provides the benefit of natural diversification as the index is made up of a variety of assets depending on the index being tracked. Thus, the risk associated with individual stocks is neutralized by the mere act of investing in an index fund.
It must be remembered, however, that the risk mitigation is at the level of the index which the fund tracks. If you invest in a fund that tracks the banking index, cross-industry exposure will not be covered.
Good returns
Finally, the proof of the pudding is in the eating. In other words, how do index funds compare with other types of mutual funds in terms of returns on the money invested.
Concluding remarks
Index funds are the recommended approach for individual investors. Investors agnostic to the sector could opt for the overall index funds such as the BSE 100 or Nifty 50, while those who have a preference for some specific type of asset could choose a fund tracking that asset or industry, say banking, or consumer goods.
Index funds investment is not a completely passive investment. You would need to choose one among the many types of index-based funds that that itself becomes an active choice. The fund needs to be active in ensuring that liquidity requirements are met while maximising returns.
There is often a tracking lag; the delay with which a fund responds to changes in the index composition. Though funds tracking the same index should deliver the same returns over a period of time, this delay could cause some variation in returns.
As is the case in any investing, while they minimise the risk for an investor, index funds are not risk-free. They are exposed to the broad industry movements. For example, in case of an economic downturn when economic activity decreases and all stock stake a beating, index based funds will also reflect the same behaviour.
Index funds carry tax implications in line with equity-funds. Dividends are included in the taxable income of the investor while income earned at the time of selling the fund is subject to capital gains tax based on the period of holding.
