Index Funds

When an index fund tracks a benchmark like the Nifty, its portfolio will have the 50 stocks that comprise Nifty, in the exact same proportions. An index is a group of securities defining a market segment. These securities can be bond market instruments or equity-oriented instruments like stocks. The popular indices in India are stock indices like BSE Sensex and NSE Nifty. Since index funds track a particular index, they fall under passive fund management. In this, the fund manager decides which stocks have to be bought and sold according to the composition of the underlying benchmark. Unlike actively-managed funds, there isn’t a standalone team of research analysts to identify opportunities and select stocks.

While an actively-managed fund strives to beat its benchmark, an index fund’s role is to match its performance to that of its index. Index funds typically deliver returns more or less equal to the benchmark. However, sometimes there can be a small difference between the fund performance and the index. It’s known as the tracking error. The fund manager will try to reduce the tracking error as much as possible.

Who should invest in Index Funds?

The investment decision in a mutual fund solely depends upon your risk preferences and investment goals. Index funds are ideal for investors who are risk-averse and want predictable returns. These funds do not require extensive tracking. For example, if you wish to participate in equities but don’t wish to take the risks associated with actively-managed equity funds, you can choose a Sensex or Nifty index fund. These funds will give you returns matching the upside that the particular index sees. However, if you wish to earn market-beating returns, then you can opt for actively-managed funds.

While the returns of index funds may match the returns of actively-managed funds in the short run, however, over longer time periods, the latter tend to do better.

Advantages

Low Cost: Index funds are passive trackers in nature and hence have low expense ratio

No fund manager error: Index funds are not vulnerable to poor management because they are not actively managed. They simply track an index.

Efficient Market Hypothesis: Major economic thinkers have lent their support to the efficient market hypothesis – the theory that no fund manager or investor can outperform the market in the long run. Price anomalies are eventually discovered by competitors and stocks are priced according to their fundamental value. Hence an index fund which represents the market will outperform all active funds in the long run.

Disadvantages

No beating the market: An investor buying into this type of fund gives up the chance of beating the market by picking a good actively managed fund.

Mature companies only: Index companies tend to be mature companies who have their best growth years behind them. Investors in such funds do not benefit from the growth potential of small companies.

Expensive Valuations: Companies in the index have been discovered by the market. In other words, investors are buying stocks which are already expensive, after they have become expensive.