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

The pros and cons of investing in index funds

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 to discretion to buy and 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 modification 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 fund 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

The index funds promise good returns over a longer time horizon since the Nifty and the Sensex have performed very well over time. The Sensex has a base value of 100 in 1979 and over the last 39 years it has given 35-fold returns. The Nifty has its base in the year 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 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. The index fund, being a passive fund, overcomes the bias and just tries to track the index.

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.

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. That is more 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.

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 are there are enough alpha opportunities index funds are likely to underperform the actively managed funds.

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.

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