Why Index funds?

Before diving deep into the question of Why Index funds, let us first understand what an index fund really is.

Generally, when we come across mutual funds, there are two broad categories to them. One is the actively managed funds while the other one is Passively managed funds.

Active funds

An active mutual fund usually has a fund manager and a team that decides upon which companies to invest into. They usually do some research in order to find the best companies to invest in that will give a higher return compared to the other mutual funds or a benchmark in general. The main idea of an actively managed fund is to find those companies which would help them beat the market index.

Passive funds

Passive funds on the other hand, while being managed by a fund manager, do not put into any research to find the companies for investing. Rather, they simply track an index and try to provide a return as close to the index.

Now moving forward, we need to know what is an index, first.

What is an Index?

As the name suggests, Index funds are mutual funds that invest in the index, but this is not as you would think it is. You cannot directly invest in an index, an index is not a financial instrument, but rather a financial measure. To put it simply, an index is a measure or rather a representation of how a particular group of companies or the market is doing as a whole. It gives us a picture of how the market is performing. You might have heard of Nifty or Sensex going up or down daily, these are the index which accounts for the top 50 and 30 companies respectively in the Indian market.

For ex- Nifty shows us the top 50 companies listed on the Indian market, but all the companies do not have the same contribution or weightage in the index. Some companies have a higher weightage in the index than the other companies. HDFC bank would be a good example since its weightage is around 10% in Nifty 50. Now one thing to keep in mind is that this weightage might change with time. How it changes is a different story.

Note, an index can be sectoral as well, which only considers a particular segment or sector in the overall economy. An example of that would be BankNifty which considers a maximum of 12 banking stocks.

Index funds

Now since we know we can't buy or invest directly in an index, then what does an index fund really do.

Index funds usually invest in stocks of each company in the same proportion as they are weighted in the index. That means if a company’s weightage is around 10% percent in the index, the index fund must invest 10% of the total capital it received into that company. This way, the index fund ensures that all the companies on the index are invested on the basis of the weightage they hold in the index. Even you can do the same thing to replicate an index fund in your portfolio, but it is quite a hassle to look into each company’s weightage which also might change and you might have to readjust. So it is quite convenient for us to directly invest in the index fund which would do all these things in exchange for a small fee which is termed as the expense ratio.

Now the main question is why index fund.

The first and foremost reason is to de-risk or diversify your investment. For new investors who have entered the market, this is a great product to start with. As opposed to investing in few companies which may prove to be bad decisions and loss-making, it is better to de-risk and diversify through an index fund that can safeguard your investments. Since index funds incorporate several companies across several sectors, it is quite diversified. For ex- A BankNifty index fund would be less diversified than the Nifty Index fund, since BankNifty in itself is a single sector, while Nifty considers all the big companies across several sectors.

Secondly, the fee(expense ratio) that is charged by an index fund is quite low as compared to an active fund. Generally, the expense ratio of an index fund is in the range of 0.10% to 0.30% annually. While on the other hand, an active mutual fund may range from 0.50% up to 1.7% annually. Now, this difference might not seem a lot at first, but the thing about the expense ratio is that they get charged each day. So it does make a lot of sense to choose a low expense ratio fund whether you are going for a passive or an active fund.

Lastly, although active funds have tried to beat the market while charging higher fees, turns out, majority of actively managed funds did not beat the index or just barely got close to the index benchmark. Apart from some actively managed funds which delivered decent returns, most of the funds just got close or underperformed the index. Now if you had invested in the active funds which had underperformed in the long run, they would have eroded the returns more since they were also charging heavy fees as opposed to average index returns charging less expense ratio.

In India, the Index funds are not that popular unlike the US, where they were first introduced by John Bogle in 1975. Although they are gaining traction, the total market share of passive funds stands around 10% in India compared to more than 40% in the US. Passive funds

So it does make sense to go for the index fund for an average return that would beat inflation in the long run but if you're all for higher returns, go ahead and choose a good active fund that would deliver so.

Here’s a link to check mutual fund's performance over the years. https://bit.ly/39TuWwA

Photo by Markus Winkler on Unsplash