Index Funds - Meaning, Purpose, How to Work, Risk, Returns

When it comes to investing, there are a lot of factors that affect the investor’s choice to park their money. Amongst those factors, it is always the ‘Risk’ and ‘Returns’ that drive the final decision of the investment avenue. It is quite common that people tend to take more risks in case of a growing market condition, in order to enjoy higher returns. However, in an economic condition which seems uncertain in the near future, investors settle for low-risk investment options. Investors go for diversification of investments for the purpose of lowering their risks. Nevertheless, it might be cumbersome for an individual to buy shares of all the listed companies. Index funds help investors overcome this complication.

What are Index Funds?

Index Mutual Funds are passively managed funds, wherein the fund manager tries to reduce the risk factor by mirroring the index. The Index funds invest in all the securities in the market (or a segment of the market), in the same proportion as in the index. These Index funds do not tend to beat the index, rather they just replicate the performance of the index. One of the major advantages of the index funds is that they are not actively managed, and hence have lower expense ratios. 

Several researches have proved that beating the benchmark index every year is quite impossible. The funds that are actively managed by managers have failed to beat the market a few times in the past. In such circumstances, the index funds have proved to generate better returns by just tracking the index performance.

How Index Funds Work?

An Index is basically a group of securities that resembles the market or its segment. The most popular indices in India are NSE Nifty (50 stocks) and BSE Sensex (30 stocks). The fund managers of the index funds procure the same securities as in the index, in the same proportion, and form the index fund. The index fund just tracks the performance of the index and generates more or less the same returns. The index fund invests in securities that are present in the index and makes occasional changes only when there is a variation in the benchmark. 

Passive Fund Management:

The Index funds adopt a strategy of passive management. On the other hand, several mutual funds follow active fund management. In the case of ‘Active Management’, the fund managers are involved in activities like market analysis, stock picking, forecasting, and timing the market, etc. The mutual funds are managed by an individual or a group of fund managers backed by a team of analysts. These professionals utilize their experience and knowledge to outperform the market. 

However, the Index funds just follow the opposite strategy. The USP of index funds is the lower expense ratio as compared to active funds. The management expense of a fund includes the fees paid to the management team, transaction costs, accounting fees and taxes. When it comes to index funds, there is no requirement for analysts and the fees paid for fund management is not as high as active funds. Also, the number of transactions is much less and hence the cost associated with transactions is minimized to a great extent. 

The index funds come with a lower expense ratio of around 0.2% to 0.5% (which could be even as low as 0.05% in some funds). The active funds have comparatively higher expense ratios in the range of 1% to 2.5%, depending on the fund type (direct or regular plan). This difference in expense ratio directly impacts the performance of a fund and results in significant variation of returns generated over long term. 

Also Read: What is Bharat Bond ETF: Meaning, Benefits, Price, Interest Rate, Review

Performance of Active Mutual Funds Vs The Benchmark:

    (Source: Valueresearchonline)

Large Cap: 

The Large Cap Mutual funds invest the corpus of investors in stocks that have higher market capitalization. As these stocks are of large firms, the risk factor is low. At the same time, most of these organizations have crossed the growth phase. Hence, they provide comparatively lower, but safe and steady returns. One of the popular ‘Benchmark Index’ for large cap securities is S&P BSE 100 TRI. 

In the table given above, the performance of the benchmark index is compared with a few of the actively managed funds. Top performing funds in the large cap category, like Axis Bluechip Fund, ICICI Pru Bluechip fund, Mirae Asset Large Cap fund have beaten the benchmark index in the 5-year, 7-year and 10-year investment horizon. These funds seem to benefit the investors even after accounting for the expense ratio. Other funds like Indiabulls Bluechip fund, Invesco India Largecap fund, JM Largecap fund, Kotal Bluechip fund have performed moderately. Although these funds have outperformed the index for short-term, the long-term returns (say 10 year returns) does not have a significant difference. Moreover, the expense ratios of these funds range from 1.5% to 2.5%. This directly affects the overall returns of the active funds and results in lower gains. 

On the other hand, passively managed large cap index funds have expense ratios ranging from 0.05% to 0.5%. Some of the top performing index funds in the large cap category includes Nippon India Index Sensex, ICICI Prudential Nifty Index Fund, HDFC Index Sensex Fund and UTI Nifty Index Fund. Hence, they provide returns which are more or less the same as the benchmark. 

Check - Best Large Cap Mutual Funds to Invest in India

Mid Cap: 

Mid Cap stocks are those of the companies which are in the middle range, when ranked according to the market capitalization. To be precise, SEBI has defined that the companies which are ranked from 101 to 250 (based on the market capitalization) come under the category of mid caps. The Mutual funds that invest a major portion of their funds are known as mid cap funds. ‘S&P BSE 150 MidCap TRI’ is one of the popular benchmark indices for the mid cap funds. 

The funds like Axis Midcap fund and DSP Midcap fund have given brilliant returns over the years. They have been outperforming the index quite consistently. 

The benchmark index has also given attractive returns over the 5-year(6.49%), 7-year(14.87%) & 10-year(9.66%) horizons. Other actively managed funds like ‘Edelweiss Mid Cap Fund-Reg(G)’, ‘Tata Mid Cap Growth Fund(G)’ and ‘Taurus Discovery (Midcap) Fund - Reg’ have generated similar returns as a result of active management by the fund managers and analysts. However, the expense ratios associated with these active midcap funds are quite higher and curtails the overall returns. Motilal Oswal Nifty Midcap 150 Index Fund is a popular Index Fund available in the Midcap category.

Check - Best Mid Cap Mutual Funds to Invest in India

Small Cap: 

When ranked according to the market capitalization, the stocks below the top 250 companies are regarded as small caps. These stocks appeal to the investors due to the high returns they generate (as these organisations are in their growth phase). The mutual funds that invest in these stocks are known as small caps and one of their popular benchmark indices is S&P BSE 250 Small Cap 250 TRI. 

Observing the data furnished in the table above, we could see that the small cap funds like SBI Small Cap fund and Nippon India Small Cap fund have generated excellent returns for its investors. Whereas, the ICICI Prudential Smallcap fund has performed quite similar to the benchmark index. 

In the Smallcap category, the index fund that is quite popular among investors is Motilal Oswal Nifty Smallcap 250 Index Fund. 

Check - Best Small Cap Mutual Funds to Invest in India

Multi-Cap:

Multi-Cap funds are mutual funds that invest their assets in the companies across the market capitalizations. These funds provide diversification benefits to the investors through their holdings in large-cap, mid-cap & small-cap stocks. Most of the funds in the multi-cap category use the benchmark “S&P BSE 500 TRI” which constitutes the top 500 companies listed on BSE in terms of market capitalization. 

There are also index funds for Multicap category (Motilal Oswal Nifty 500 Fund - Regular Plan, SBI Focused Equity Fund & Kotak Standard Multicap Fund Regular Plan) and Foreign Equity Index Funds (Motilal Oswal S&P 500 Index Fund - Regular Plan & Franklin India Feeder Franklin US Opportunities Fund)

Check - Best Multi Cap Mutual Funds to Invest in India

Active Funds Performance over their Benchmarks

In our analysis, we have gathered the returns data of the equity fund categories: Large-cap, mid-cap & small-cap funds as well as the returns generated by their respective benchmarks to compare their performances return wise over the periods of 1 year, 3 years, 5 years & 10 years.Through this, we have come out with the following findings:

1 Year Period

Over the 1 year period, 17 funds(or 58.62%) out of the 29 active funds in the large-cap category, have managed to beat the returns of their respective benchmark indices. The numbers are higher for midcap funds & small-cap funds i.e in the mid-cap category, out of the 23 active funds 17 (about 73.91%) have managed to beat their respective benchmark’s returns and in the small-cap category,15 out of 21 active funds (or 71.42%) have been able to beat the returns of their respective benchmark indices. 

3 Year Period

Over the 3 year period, only 3 out of the 28 active funds in the large-cap category have managed to beat the returns of their respective benchmark indices. Whereas, the numbers are notably higher for midcap funds & small-cap funds i.e in the mid-cap category, out of the 22 active funds 15 funds (about 68.18%) have managed to beat their respective benchmark’s returns and in the small-cap category,12 out of 14 active funds (or 85.71%) have been able to beat the returns of their respective benchmark indices. 

5 Year Period

Over the 5 year period, most of the small-cap active funds have been able to beat the returns of their respective benchmarks whereas most of the large-cap active funds have not been able to do so. In the mid-cap category, only 9 out of 21 funds (or 42.86%) have been able to beat their respective benchmark’s returns.

10 Year Period

Over the 10 year period, only less than half of the large cap active funds (11 out of 23) have been able to beat their respective benchmark’s returns. Whereas, all the Small cap funds in the category have been able to beat the returns of their respective benchmarks. Also, most of the midcap funds(15 of 17) have managed to beat their benchmark’s returns. 

Conclusion:

In each category, we have funds that have been able to outplay the benchmark indices pretty consistently. These funds leverage the experience and skills of the fund managing team to beat the market on a regular basis. At the same time, there were also instances where the benchmark has bettered certain funds over time. This is on grounds of the diversification advantage provided by the index. This enables the Index funds to exceed the performance of a few active funds. The index funds as they have minimal expenses, which is way lower than the actively managed mutual funds. The index based funds are hassle free and do not require much information about the market for stock selection, analysis, timing, etc.

Also, the mutual funds market is getting highly competitive. It has become quite difficult to choose the right fund manager who might provide extraordinary returns than the others. One might consider that they could choose funds based on their historical performances and their rankings. At the same time, we must not forget that the ranking keeps changing from time to time. This clearly implies that it is difficult for a fund manager to outperform the market at all points of time. 

Moreover, in developed economies like the USA, the benchmark indices have proved to perform better than active funds over years. This is because the entire market quite represents the whole of the country’s economy rather than selective few stocks. In the coming years, we might also witness the same condition in developing economies like India as well. 

In addition to all the above said factors, we could also see that investors flock towards index based instruments like ETFs and Index funds, whenever there is high economic uncertainty in the market. As it becomes hard to predict a highly volatile market in a crisis, investors could realise that investing in tools replicating the whole market might be safer. In our country, the Index funds could be considered for investments in the future more than what it is now.

More Information: 

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What is Expense Ratio in Mutual Funds

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Best Mutual Funds to Invest in for Long Term in India

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