The pros and cons of investing in index funds - Motilal Oswal

The pros and cons of investing in index funds

There are pros and cons to using stock indexes and also using the index funds that track them. Broadly speaking, an index represents a portfolio of securities which stand for the wider marketplace. The stock index offers a statistical measurement of prices of stocks in a particular portfolio when you consider that portfolio of a range of funds. Typically, an index is created with the use of shares of top companies in the sphere of an economy, or in a specific sector of the economy. So, how to invest in index funds, then? First, you should find out more about them. 

 

Index funds are the ultimate example of passive investing. We need to understand passive investing as opposed to active investing. In active investing, the fund manager has the discretion to buy stocks so as to enhance returns for the fund holders. Diversified equity funds are examples of active funds. An index fund purely invests its corpus in the index. 

 

For example, if the index fund is benchmarked to the NSE Nifty, then the fund will buy all the stocks in the index in the same proportion as the index. It is only when the index weights change or when stocks are added or deleted from the index that the index fund manager needs to make modifications to the index fund portfolio. The idea behind an index fund is to replicate the index returns as close as possible. Let us look at the pros and cons of investing in index funds. What are the benefits of investing in index funds and what are the strong reasons to invest in index funds? Let us look at the various perspectives..

Advantages of Investing in an Index Fund

How to invest in index funds is easy enough to understand if you know about their advantages. 

  • The index funds promise good returns over a longer time horizon since the Nifty and the Sensex (two main indexes) have performed very well over time. The Sensex had a base value of 100 in 1979 and over the last 39 years and it has given 35-fold returns. The Nifty had its base in 1995 and has given 11-fold returns over the last 23 years. What it means is that even if you had invested in an index fund, you would have still made good returns over the last many years. Index funds, it is important to note, have the ability to give you moderate to good returns over time as funds comprise stocks of leading companies. These are usually robust with a great financial history to back them. 

 

  • Index funds overcome the bias of human discretion. That is the big problem with most diversified equity funds. There is a very strong element of discretion that is given to the fund manager. Thus, the fund manager’s conditioning, biases and past experiences make a difference to the investment strategy of the fund. In an index fund, these are completely eliminated. The index fund, being a passive fund, overcomes the bias and just tries to track the index. You may think a fund manager is a benefit, but without any human error in the picture, you can make sure your investments are free from fault. 

 

  • Costs in an index fund are substantially lower. In fact, in the previous annual general meeting of Berkshire Hathaway, Warren Buffett had lauded the efforts of John Bogle, the founder of Vanguard Funds. It may be recollected that Vanguard is one of the world’s largest asset managers with over $4.30 trillion in AUM. Buffett pointed out that Vanguard had saved billions of dollars in costs to mutual fund investors by adopting an index based strategy. This helps you to save more while you invest to earn high rewards. 

 

More About Index Funds in India and How to Invest in Index Funds

Indexes first gained a lot of popularity with the DJIA (Dow Jones Industrial Average). This was established by Charles Dow in 1896. This was the second index, but gained popularity as it became a vital instrument to track the economy in a broad sense. Since that time, other stock indexes have made their presence felt, namely the NASDAQ and the S & P 500 in the US, and the Nifty in India. Indexes track other assets, besides equities, like commodities and bonds too. 

 

India, unfortunately, has not taken an affinity to index funds, although this may change in the future. Many diversified funds in India today are largely a reflection of index funds as a major proportion of their portfolio is invested in index heavyweights. Therefore, you end up paying a higher Total Expense Ratio (TER) for marginal return benefits. Index funds help you to overcome this challenge.

 

Index funds have not taken off in a big way in India, and the reason for this is because more than 70-75% of the fund managers actually beat the index in India while in the US it is just about 10-15%. Once the index methodology becomes tighter and information flow more efficient, the returns between active funds and passive funds will reduce to a much lower spread.

 

Just like you invest in any other kinds of funds, how to invest in index funds in India is easy. First, you should sign up with a good broker, and select the index that you wish to track. Then, you can pick a fund that tracks the index you have chosen. The last step is to purchase shares in the index fund chosen. 

Challenges of Investing in Index Funds

  • Fund manager discretion works better in case of active funds when asset allocation decisions have to be taken. For example, if the equity fund manager finds the market to be too volatile, then the cash allocation can be increased substantially. However, an index fund does not have that flexibility as it has to be fully invested in the index at all points of time.
  • While index funds are free from the fund manager bias, they are still vulnerable to the risk of tracking error. It is the extent to which the index fund does not track the index. Tracking error may occur in an index fund due to liquidity provisions, index constituent changes, corporate actions etc. This is a major risk in index funds.
  • Index funds do lose out on the expertise of the fund manager and the structured investment approach that an active fund manager brings. At least in a country like India, where there are enough alpha opportunities, index funds are likely to underperform the actively managed funds.

 

Index Funds and the Way Ahead

An investor needs to remember that index funds have not been great performers in the past. However, it is surely an idea which may become a lot more attractive in the coming years.

You must remember that an index gives a brief and rapid measure to evaluate the market. If you wish to know the state of any marketplace, all you have to do is study an index. Moreover, index funds give you a low-cost method to invest. They can also bring you good gains than fund managers do, and aid in your achievement of investment and financial goals. This is great on one hand, but on the other, index funds put a lot of weight on stocks in the large-cap category. Thus, funds may need the abilities of a fund manager and this is not present with index funds. However, if you do some research on index funds, you will discover that several respected investors and academics place a great deal of importance on such funds, prompting investors to go ahead and invest. 

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