The investment world is full of thousands of options to invest in.
A new investor is merely aware of few funds or hot stocks, as they are discussed frequently in television and other social media channels.
To understand various different types of Mutual Funds, you should read this Comprehensive Guide to Mutual Fund Investments.In this particular article, we will focus our discussion about Index Funds, which is one of the categories of Mutual Funds. After reading this article, you will understand Index Funds in greater detail and you will be able to make an informed decision on whether to invest in index funds or not!!
Let’s read on and discover Index Funds.
What are Index Funds?
Index funds, as the name suggests, invest in an index.
- An index fund is basically a portfolio of stocks or bonds which mimics the performance of a financial market index, eg. Sensex, Nifty, etc.
- Index funds follow a passive investment strategy.
- Index funds have lower expenses and fees than actively managed funds.
These funds purchase all the stocks in the same weightage as in a particular index, such as Sensex, Nifty or other indexes.
Index funds are ideal for investors who are risk-averse and expect predictable returns. These are the passively managed funds. Index funds are not meant to outperform the market, but mimic the performance of the index.
Some examples of Index Funds are:
- Reliance Index Fund – Sensex Plan
- ICICI Pru Nifty Next 50 Index Fund
- Franklin India Index Fund Nifty plan
Types of Index Mutual Funds in India
Sensex Index Funds
These index funds track BSE SENSEX as a benchmark index invest in 30 companies on BSE Sensex. These Types of Mutual Funds are backed by ETF’s (Exchange Traded Fund) traded on the exchange. ”
Nifty Index Funds
These index funds track NSE NIFTY 50 as a benchmark index invest in 50 companies on Nifty 50. These types of Mutual Funds are also backed by ETF’s (Exchange Traded Funds) traded on the exchange.
Nifty Junior Index Funds
These index funds track NSE NIFTY Junior 50 as benchmark index invest in 50 companies on NSE NIFTY Junior 50. These types of mutual funds are backed by ETF’s (Exchange Traded Funds) traded on the exchange.
There are many other types of index, such as G-sec index(tracks bond/commodity), Nifty Bank Index, Nifty PSU Bank Index (which tracks banking index) and International Indices such as NASDAQ-100, Hang-Seng Index, etc. (tracks an international index).
BSE SENSEX and NSE NIFTY 50 are the most popular indices in India.
Index Funds vs. ETFs: 10 Points comparison
Before we compare Index Funds and ETFs, let us understand, what is an ETF?
ETF stands for Exchange Traded Fund. ETF tracks the stock market index and trade like regular stocks on the exchange. Types of ETF are:
- Index ETF,
- Bond/Commodity ETF,
- International ETF,
- Gold ETF etc.
Out of the above listed ETFs, Index EFT works quite similar to Index Funds with a couple of differences highlighted in the table below:
| Element of Comparison | Index Funds | ETF |
|---|---|---|
| How do they trade | Index funds trade like Mutual Funds | ETF trade like other stocks. |
| The need for Demat or Trading Account | Index Fund does not need a Demat or Trading Account | ETF requires a Demat and trading account. |
| Structure | Index Funds keep a higher percentage of assets like cash and liquid securities. This leaves tracking errors, higher the error greater the deviation from Index returns. | ETFs also hold some cash or equivalent for liquidity but it is much lesser than Index Funds. These track the Index more efficiently than Index Funds. |
| Basis for pricing | NAV of the underlying asset. | Demand and supply of the security/stocks in the market, |
| Trading Cost | No transaction fees. But there will be Expense ratio charges. | Higher transaction costs, along with expense ratio, annual fees, and brokerage charges. |
| Expense Ratio | Comparatively High (min value is 0.1% and higher) | Low (min value is 0.05%) |
| Initial investment | SIP could start from Rs.500/- and onwards. And, Lumpsum investment may start from Rs. 5000/- | No minimum investment |
| Settlement Time | Minimum 1 to a maximum of 3 days. | At least 2 days after a trade is placed. |
| Transaction | Could buy and sell like any other Mutual Fund. Systematics transaction like SIP, STP, and SWP is also possible. | ETFs are bought and sold at the exchange and need a Demat Account to execute transactions. Systematic investment cannot be done. |
| Liquidity | No Liquidity risk. To liquidate an Index Fund, a redemption request can be made to the Fund House. The redemption amount will get credited to your bank account within a week’s time. | High liquidity risk. There might be no buyers when the seller wants to sell ETF shares. Or, the seller may have to sell the ETF units in a lower redemption amount! |
Should you invest in Index Fund (in India)?
In short, the answer is NO. Below are the precise reasons why you should avoid investing in Index Funds:
1. Index Funds provides lesser flexibility
The fund manager merely follows the changes in Index; they do not have any flexibility to make any change in the portfolio, even though they found it to be necessary.
Whereas in actively managed funds, a Fund manager has the flexibility to rule out an unproductive fund or add any progressive fund in the portfolio whenever required or whenever he feels the right time to make changes.
Right changes at the right time ensure better returns on the investment.
But in Index funds, there is no flexibility to make such changes.
2. Index Funds generate average returns
Most of the active fund managers can easily beat the returns of index funds in the long run. Whereas in Index funds, Fund managers don’t play a significant role and also they have very restricted flexibility, as compared to their active counterparts; as discussed above.
The table given below lists some of the top Large Cap Funds; have a look at their 1-year returns! For Index Funds and ETFs the returns vary between 5%-6%.
Whereas for actively managed funds, such as Axis Bluechip Fund, the 1-year return is 17% -18%.
Notice a huge difference of 10% – 12%, by which the Index Funds fall short in their returns as compared to the other actively managed Large Cap Funds. There are various other actively managed Large Cap Funds such as Mirae Asset Emerging Bluechip Fund, SBI Bluechip Fund or ICICI Prudential Bluechip Fund which easily outperform the Index Fund in terms of generated Returns. 
3. Index Funds sticks with the stock till they are kicked out
The stock price fluctuates every second in the share market. This fluctuation may not be a big deal for the big companies that are at the top ranking at the index, Sensex or Nifty.
However, at the bottom of the index table, there are some companies that drop out of the list, while many other companies manage to take a place in the list of top-30 or top-50, in the Sensex and Nifty index table.
As a result, the BSE/NSE periodically drops some companies from the Sensex/Nifty due to the company’s non-performance in the stock market.
Now, what does the index Fund manager will do?
They will hold on to the dropped companies until the last moment while they are in the index. While active fund managers sell them weeks or months, much before they are dropped from the index!
Also, the Index fund managers won’t start buying the newly added companies until the company is officially added to the index. Whereas, other active fund managers already have new and better stock in their hand, whenever they choose to have.
4. Index funds buy high and sell low
Till the time leading index (Sensex or Nifty) holds these stocks, you are stuck with these, even though you know that these are not going to perform!
And, the companies which form the part of the index usually gain in market capitalization and therefore their stocks become expensive. The fund manager of the index fund has to buy more of such expensive stock to maintain the required weightage.
The stock will be sold only when the fund is no longer in index (as described in the above section), that is, when the cost would touch significantly LOW! As compared to the cost the stock was purchased.
Therefore, Index Funds are sort of an automatic procedure of buying high and selling low!
Some Advantages of Index Fund and its implications
-
Least expense ratio among the equity funds
- But the expense ratio is not the only factor which determines the quality or good returns of any fund
-
Diversified in all stocks of the underlying index
- Diversification is the common benefit of all Mutual Funds; its not unique only for Index Funds.
-
Least risky, since they merely replicate the index and are not dependent on the decision making of the fund managers.
- Fund managers of the Active Funds outperform the index funds. Index fund managers don’t play any significant role in the investment of the index fund.
Conclusion
You should avoid investing in Index Funds. You should make your financial goals and invest accordingly in other actively managed funds. For more details, you should read this article on, “How to Invest in Mutual Fund?”
If you have any further queries or your experience to share on Index Funds, feel free to post in the comment section below.
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