What are Index Mutual Funds and why are they a trend in India?

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Before starting with index mutual fund, Let us first understand what is an index? 

What Is an Index?

A stock market index is created by selecting a group of stocks that represents the whole market or a particular segment of the market. In India, we have Sensex and Nifty as the two most popular indices. Both of these indices are created by including the companies with highest market capitalization (in simple terms largest companies). Sensex includes 30 and Nifty includes 50 largest companies of the Indian stock market. These indices have proven track record and to invest in them, index funds are one good source.

What is an Index Mutual Fund? 

Index Mutual Funds are the form of passive fund management i.e. Instead of a fund portfolio manager actively stock picking or market timing, it simply builds a portfolio whose holdings mirror the securities of a particular index. In simple terms, it replicates the performance of an index by buying all the same stocks and in the same proportion as index. 

Since Index mutual funds are not actively managed, they have a lower expense ratio comparing to any other equity mutual funds. Also, investing in Index funds has a comparatively lower risk. Therefore, investors who have long-term financial goals with medium risk appetite should invest in such funds.

How do Index Mutual Funds Work?

Under Index mutual funds, fund manager simply buys all the stocks in a particular index in the same proportion as that index holds and then issues the units for the funds to different investors on a pro-rata basis.  No active decision is taken regarding the stock selection and the fund is rebalanced only when any change takes place in the index itself - which occurs rarely. For example, in the case of nifty, the rebalancing occurs only twice a year. Therefore it reduces the transaction costs and taxes drastically compared to an actively managed funds. 

Index Funds (Passively Managed Funds) vs Actively Managed Funds

Investing in an index fund is a form of passive investing. The opposite strategy is active investing, as realized in actively managed mutual funds—the ones with the securities-picking, market-timing portfolio manager described above.

The advantage with the index mutual funds of lower management expense ratio will always be there. A fund's expense ratio, also known as the management expense ratio includes all of the operating expenses such as the payment to advisors and managers, transaction fees, taxes, and accounting fees.

Since the index mutual fund managers are simply replicating the performance of a benchmark index, they do not need the services of research analysts and others that assist in the stock-selection process. Also, the number of transactions is less under index mutual funds comparing to any actively managed funds due to which, it incurs fewer transaction fees and commissions. In contrast, actively managed funds have bigger staffs and conduct more transactions, driving up the cost of doing business.

The fund's expense ratio are pass on to investors. As a result, cheap index mutual funds often cost less than a percent—0.2%-0.5% is typical, with some firms offering even lower expense ratios of 0.05% or less compared to the much higher fees actively managed funds command—typically 1% to 2.5%.

Expense ratios directly impact the overall performance of a fund. Actively managed funds, with their often-higher expense ratios, are automatically at a disadvantage to index mutual funds, and struggle to keep up with their benchmarks in terms of overall return.

How expense ratio affects the overall returns?

Let's assume both the actively and passively managed funds give 12% return annually. Now, since the expense ratio is higher in the case of actively managed funds, let's take 1.5% then the return for this fund after deducting the expenses will be approximately 10.5%. On the other side, the expense ratio is lower in the case of passively managed funds, let's assume 0.25%, then the return for this fund after deducting the expenses will be approximately 11.75%. 

To make it more clear, let's take an example of investing  ₹1,00,000 in both the funds. The actual return for actively managed funds after 10 years will approximately be ₹2,71,400 and the return for the passively managed fund will be approximately ₹3,03,700. The difference of ₹32,300 is coming just because of an extra 1.25% of the expense ratio. This amount will keep on increasing if the investor increases his/her investment time horizon.

Things to Consider while Selecting an Index Mutual Fund

  • The biggest advantage of Index fund is its lower expenses. Therefore while selecting the Index mutual fund, these expense ratio should be considered thoroughly.
  • Past returns could be one of the parameters to judge which index mutual fund is better. But do check the returns for at least last 12 months, 3 years and 5 years before finalizing any fund.
  • Fund manager’s knowledge and experience don’t matter much in the case of index funds. What actually matters is their tracking skills i.e. how efficiently they replicate the index.
  • Tracking error i.e. difference between index funds return and the index return should be minimum.
  • When investing in an index mutual fund, the investment time horizon should be long. At least for 8-10 years for good returns.
  • Since index mutual funds map an index, they are less prone to equity-related volatility and risks. Hence they are amazing options during a market rally to earn great returns.

Top 5 Index Mutual Funds in India

The following table represents the top 5 index funds in India, based on the past 5 year returns. Investors may choose the funds based on a different investment horizon like 1, 3 or 5 years returns. You may include other criteria like investment style, financial ratios, target sector as well.

Fund Name
UTI Nifty Index Fund Plan Growth
IDFC Nifty Fund Growth
HDFC Index Nifty 50
Aditya Birla Sun Life Index Fund Growth
Franklin India Index Fund Nifty Plan Growth

Overview of Nifty Index

The NIFTY 50 index is a well-diversified 50 companies index reflecting overall market conditions. NIFTY 50 Index is calculates using free float market capitalization method.

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Nifty 10 year return India for Index funds

Conclusion

In the long run, it is almost next to impossible for any fund manager to continuously beat the market. Moreover, that extra 1-2% expense charged by the actively managed funds has a substantial impact on the overall returns. Therefore, in the developed market, index funds perform well above any actively managed funds and something similar is expected in India as per the experts. 

Comments (3)

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    Avinash gaurav01/10/2019

    Thanks for sharing.....

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    Avinash gaurav01/10/2019

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    Avinash gaurav01/10/2019