A guide to index investing

In India, traditional investment classes with little to no risk have been the favoured investment path for the older generations. The younger demographic of retail investors though are shedding those inhibitions and are slowly gravitating to more profitable pastures and foraying into riskier investment avenues.

Among asset classes that are being preferred by this coterie of investors, mutual funds top the list but the narrative around mutual fund investments and how they are managed can look too tricky for many investors especially those new to the investment game.

This is where passive index funds can fill in the gaps for investors who are struggling to navigate the terrain of actively managed funds. Meeting asset allocation objectives and maintaining optimum diversification in one’s portfolio can be made a simpler exercise with index funds.

What are index funds?

An index fund is a type of mutual fund scheme wherein the portfolio is built to mirror the components of a financial market index such as the NSE Nifty. When you invest in an index fund, your money is invested in all the companies that make up the particular index the fund is replicating.

For instance, if a mutual fund scheme has a Nifty 50 Index Fund, it would have investments in the same 50 stocks in its portfolio that make up the Nifty 50 Index. It is important to note that the weightages of the stocks in the fund would be congruent with those in the index against which the scheme or the fund is benchmarked.

The history of index funds is a fascinating one. The first index fund was launched in 1976 by John C. Bogle, also known as Jack Bogle, the founder of Vanguard, an American asset management company. The fund, initially called the First Index Investment and tracked the S&P 500 index and was later renamed as the as the Vanguard 500 Index Fund. The launch of the fund was an abject failure and was received with a lot of criticism. However, the fund crossed the $1 billion mark in 1990 and as of Sept 16, 2022, the total assets under management stands at $261.7 billion and is one of the largest mutual fund schemes in the world.

India has joined the passive investing bandwagon only recently as opposed to Western countries where passive investing practices have attained sophistication. According to a report by S&P Global, as of March 2020, global assets in passive products passed USD 5 trillion, with over 7,000 passive products. The U.S., with a market share of 68%, USD 3.6 trillion in assets, and over 2,000 products, is followed by Europe and Japan with 16% and 6.5% of market share, respectively.

The passive investment landscape in India is showing encouraging trends – during the last 5 years, passive funds AUM has increased from ₹52,368 crores as on 31 March, 2017 to Rs. 4,99,319 crores as on 31 March, 2022 (annualized growth rate of ~57%) and in this period, the number of passive funds available in India has also grown from 84 as on 31 March, 2017 to 228 as on 31 March, 2022.

Preeti Zende, a SEBI registered investment advisor and the founder of Apna Dhan Financial Services says, “Index funds also called passive mutual funds and they are not managed by active fund managers – they simply follow the market index to which they may be attached. So if that index increases in value the value of the passive mutual fund also increases. Investors can choose from different index funds that mirror different indices.”

Advantages of investing in index funds

• Lower expense ratio: Instead of a fund portfolio manager actively choosing stocks and managing the fund by choosing securities to invest in and timing the market to buy and sell them, index fund managers build and maintain portfolios by imitating the holdings of the securities of a particular index. The idea is that by mimicking the index, the fund’s performance will exhibit similar trends. Since the fund manager is not actively involved in buying/selling securities, index funds have lower expense ratios compared to their actively managed counterparts.
• A smaller room for errors arising due to human bias: In the case of actively managed funds, the discretion of the fund manager has a strong bearing on the fund’s performance. The fund manager’s biases, past experiences, and perceptions can heavily colour the fund’s investment strategies and this increases the room for errors. On the contrary, in the case of index funds, the method of investment is largely regulated and automated because the fund manager has a clear idea of the demarcation of investments in different assets or stocks in the fund which reduces the possibility of errors due to biases. Index funds can also be a convenient stepping stone into the riskier world of equities for novice investors who may not possess the requisite know-how to dabble in stocks by themselves.
• Broad market exposure: Companies in India are categorized under different indices on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) based on the industry they belong to and their market capitalizations. Investment in index funds offers investors the advantage of diversification – your money will be invested in not just one company but across companies, sectors, and market capitalizations thus helping you construct a robust portfolio. The benefit of broad exposure holds true in the case of fixed income indices too that include assets such as government securities, T-bills, corporate bonds, and commercial papers.

Broad-based index funds can come in handy if you are looking to diversify your portfolio. Broad-based index funds, as the name suggests, track the returns of a broad-well-established index that comprises hundreds of securities or an entire market. For example, an index fund tracking the NIFTY 500 index would be a broad-market index fund. The top 500 listed companies on the NSE fall under the ambit of the NIFTY 500 index and so when investors invest in a fund which has the NIFTY 500 as its benchmark, they would be effectively investing in the top 500 companies of that exchange. Broad-based index funds can offer investors a wide market exposure across the market capitalization spectrum and can help risk-averse investors gain equity exposure.

Index funds can be a great addition to your portfolio for your long-term goals. In the short term, index funds can experience fluctuations but over a period of time index funds can generate attractive returns what with volatility risks being smoothened out. Zende says, “In index investing, the fund manager’s intervention is non-existent. So there is little probability of generating alpha but your risks too will be lower than actively managed funds. Your returns from index funds will be similar to the indices returns. You have to be investing in index funds for a longer time to generate wealth.”

She further elaborates, “Index investing is helpful in the long run as it eases the tension of investors what with risks entailed due to the errors on the part of the fund manager, sudden changes in the fund house’s investment philosophy as well how the fund is going to behave in comparison with the indices.”

Action points

• With more and more fund houses expanding their index fund offerings, it is advisable to thoroughly research your options before picking a fund. Check whether the fund aligns with your investment horizon and risk appetite.
• In the case of actively managed funds, managers have the freedom to choose from countless strategies to generate alpha – the managers take structured investment decisions based on real-time developments and this allows them to reap higher profits. However, index funds offer investors limited reactive ability – for example if a stock is overvalued and its weightage increases in the index, investors of the index funds cannot by themselves make a choice to lower the exposure of their portfolio to that stock. It is important to bear this in mind before investing in index funds.

This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.