What are Index funds? Why have they become popular? How to pick right one

Retail investors in India prefer index funds over exchange traded funds when it comes to passive investing. According to a survey by Motilal Oswal Asset Management Company (MOAMC), 87 percent of the respondents invest through index funds, while 42 percent of the respondents invest through ETFs. Low cost, simplicity and market returns were cited as reasons for choosing index funds.

The survey was conducted during February-May 2023 and involved more than 2,000 investors across fund houses spread across the country. Around 56 percent of the respondents were in the age group of 18-35 years, whereas 54 percent live in metro cities. Sixty-one percent of the respondents reported their annual income to be less than Rs 10 lakh.

What are Index Funds?

An index fund is a type of passively-managed mutual fund that tracks and tries to replicate the performance of a market index such as the NIFTY 50, NIFTY Next 50, Sensex, etc. To replicate the performance of its chosen index, Index Funds hold the shares that comprise the chosen index in the exact same proportion as the index being replicated.
For example, in an  actively managed Mutual Fund, you will invest your money in a scheme and then a fund manager will take tactical calls including which stocks to buy or sell and at what price to build a portfolio of securities. This will involve multiple buy and sell transactions, so, is called active investing.
In passive investing, the Fund Manager will build portfolio of stocks and maintains individual stock allocations in the same proportion as the index being replicated. Instead of picking and choosing which stocks to invest in, the fund manager will only replicate the portfolio of the chosen index.
Data analysed by Motilal Oswal shows assets under management of Passive Funds has grown 38x over the last eight years, from Rs 20,000 crore in 2015 to Rs 7.6 lakh crore today.
Index Funds that replicate specific indices like the NIFTY 50, NIFTY Midcap 150, etc. follow this strategy.

The growing popularity of index funds

Index Funds and Other ETF Flows Trend

Source: AMFI. Data as of June 2023. Amount in INR crore.

During the first quarter of fiscal 2024, there were nine schemes that were launched in the index funds category. Cumulatively,  40 index funds t were launched in the first half of calendar-year 2023; of these, there were 31 fixed-income index funds and nine equity-based index funds. In the last quarter ended March 2023, passive index funds garnered Rs 26,269 crore, shows data analysed by Morningstar.

In the last one year alone, assets of the index funds category have witnessed a phenomenal 110 per cent increase over the last year. With a total of 185 schemes now, the subcategory has assets of Rs 1,75,468 crore. These include both the equity index funds as well as fixed-income index funds, showed data from Morningstar.
Why so popular?
The spike in flows in this segment could be attributed to the change in tax laws for the fixed-income mutual funds from fiscal-year 2023-24, which takes away the indexation benefit offered to investors until fiscal 2022-23. Investors therefore largely chose to invest in these funds to avail the benefit of indexation before the end of the financial year. With the change in the fiscal year from April onward, the amount of fixed-income index funds in the June quarter was muted.
“Investing in index funds, like the Nifty 50 or Sensex in India, involves investing in a broad market index of the largest companies in India. Over most 5 year periods this has been a successful investment strategy with the Index funds handily beating a majority of active funds,” said  Gaurav Rastogi, Founder & CEO, Kuvera.in.

Who should opt for Index Funds?

“Index funds are generally best suited for long-term investors. They aim to provide consistent returns over the long run. Investors prefer this as the performance of the index fund usually closely mirrors that of the index, with no hands-on management necessary. Also, they provide instant diversification across a wide range of stocks or securities. By investing in an index fund, you gain exposure to multiple companies and sectors, reducing the risk associated with individual stock picking,” said Adhil Shetty, founder of Bankbazaar.
Why do investors prefer Index Funds?
Index funds often have lower expense ratios compared to actively managed funds. Since they aim to replicate the performance of a specific index without the need for active management, they incur fewer costs, which can lead to better net returns for investors.

“Globally passive index funds have been gaining favour with investors due to lower fees. In advanced countries, the majority of active funds underperform the index. This has resulted in more popularity for index funds. In India, the time is yet not right as the size of mutual funds as a percentage of total market capitalisation is still small, but it is an emerging trend,” said Bharat Phatak, Director, Scripbox.

” Index funds provide diversification benefits as investing money in proportion to that of an index across all stocks and sectors. One of the biggest advantages of investing in these funds is the low expense ratio, as fund managers just mimic the underlying benchmark and no research cost is involved to choose or identify the best scrips,” noted Palka Arora Chopra. Director, Master Capital Services.

“Index funds charge much lower expense ratios, i.e., 0.3%-1.5%, than actively managed mutual funds and provide returns in line with the underlying benchmark such as Nifty 50, Nifty 100 etc. Thus, it is a simple and cost-effective way for investors to generate wealth over the long term (8-10 years or more),” said  Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth

While the market may undergo a few up-and-down cycles during this period,,imvestors must stay patient with their chosen funds to let the compounding have its full effect.

Since index mutual funds mimic their benchmark index, there is no significant difference in the performance of two funds tracking the same benchmark, except for the tracking error.

Should one time the market to opt for an index fund?

Chaitali Dutta of Azuke Personal Finance Advisory believes the best time for Index funds would be when the markets correct significantly (more than 5%). She suggest that in the meanwhile investors can create that fund for Index allocation by booking profits from your equity investments that are sitting on large profits and most of that has accrued since March 2023.
How to pick the right Index Fund
Index funds are best suited for risk-averse investors for long-term financial goals.

Index funds can be filtered after evaluating their past performances and the kind of returns they have generated in the long run for investors. While past performance is not indicative of future results, analysing the historical performance can give you an idea of how well the fund has tracked its benchmark over time.

Before you choose the right Index funds, you should also evaluate which segment or sector is missing from your portfolio that is expected to do well in the mid to long term.
You should pay attention to two factors – tracking error and expense ratio

Expense Ratio: The fund operation and management expenses are charged to the NAV of the fund. “For index funds, this may typically be about 0.30%. The expense ratio of index funds is lower than active funds, where the expenses could be 1.50% or more,” said Phatak.
Tracking error : The index fund will get money from investors on a day to day basis. Some investors will also redeem their investments. Dividends received from the underlying shares will also have to be invested. Due to these, the NAV of the fund may differ from the index. For example, in a year the index went up by 13.50%, but the index fund went up by 13.30%. The difference of 0.20% is the ‘tracking error’.
“For both of these, the lower the better! The AUM size of the fund also assumes importance, as expenses get spread over a larger base,” added Phatak.

” With index funds it doesn’t matter if the fund has been around for long or who the fund manager is as long as tracking error is low. Focus on broad index categories like large, medium or small cap index and avoid thematic index funds unless you are an expert in the underlying theme. If you want to be a passive investor and want your wealth to compound over time with little interference, you can have your entire equity portion of your  portfolio allocated to index funds,” said Gaurav Rastogi, Founder & CEO, Kuvera.in.

Investors can go with more than one index fund to diversify their portfolio. “For example, you can invest in a Nifty-50 and a Nifty Next 50 fund to get exposure to India’s top 100 listed companies,” said Kuklarni.

Which are the best ones currently?

Experts Business Standard spoke to named HDFC Index Fund, Nippon India Index, ICICI, TATA Nifty 50, SBI Nifty Index fund, Aditya Birla Sun Life Nifty 50 Index funds, Bandhan Nifty 50 Index Fund among other as the most popular ones.

“SBI Magnum Midcap fund, Mirae Asset MidCap fund, HDFC Midcap Opportunities fund are all in the top of the list in the mid-cao space.  Similarly in the small cap space, Nippon India Smallcap fund, Kotak Smallcap fund, ICICI Pru Smallcap funds are top ones that may be considered. There are options like NIFTY Next 50, BSE Low Volatility index fund in addition to Sensex and NIFTY tracking Index funds,” said Dutta.

“Investors should go long on broader market indices like Nifty 250 smallcaps, BSE 500 midcaps. Although these sectors are volatile, the exposure is not limited to specific sectors. Here, we have sectors like Capital goods, FMCG and Chemicals which augurs well with India’s growth story. Credit growth offtake is going to coincide with the peak NIM effect.  A look at the returns in the past year: Nifty 50 index (11.75%), Nifty 250 smallcap (26.85%) and BSE 500 midcaps (19.65%). We have witnessed these companies give improved revenues and EBITDA margins and positive management commentary. For an investor who is looking for passive returns and is sitting on cash, should allocate to index funds,” said Anchal Kansal, Research Analyst at Green Portfolio PMS.

How much should you allocate?
The allocation of funds largely depends on your investment goals and risk tolerance despite fluctuations in the value of your investments.

“Define your goals such as funding a marriage or higher education, or buying housing etc. You must remember that a longer time horizon and your ability to stay invested despite ups and downs could promise more potential growth,” said Shetty.

As per the rule “100 minus age” one can invest in the equity market 100 minus your age and the rest in fixed-income products.

Chopra explains this with an example:  If your present age is 35 years. You can invest =100-35=65% in the equity market and the rest 35% in fixed-income instruments. There is no such specific formula or basis for % investment in active equity funds or passive (index) equity funds. For first-time investors or conservative-type investors- Index funds make a lot of sense as the majority of these funds invest in large-cap companies.

“For someone just starting the equity investment journey, with a horizon of 7-10 years, the best place to start would be a NIFTY index fund like HDFC Index -NIFTY 50 plan or ICICI Pru Nifty 50 Index fund, with 50% of the long term investable surplus and preferably with the SIP route. For a person having a larger portfolio with a 2-3 years’ experience in equity investments could allocate 10-15% of their equity investments into Midcap and Smallcap index funds,” said Dutta.

Any word of caution? 

” The big mistake people are making these days is getting carried away with all the noise and publicity surrounding ‘lower cost’ index funds without realizing that there’s a huge investing universe outside of just large caps. These index fund proponents are using developed markets (where passives are significantly more popular than active funds) as an incorrect analogy. In India, most top performing mid cap, small cap, flexi cap and thematic funds still comfortably outperform index funds even on a cost-adjusted basis and will continue doing so for several years more until domestic participation in equities goes up to the point that information asymmetry is literally non existent, as is the case in more mature markets,” said Mayank Bhatnagar, Chief Operating Officer, FinEdge.

For SIPs, the higher volatility of categories like small caps and mid caps can potentially add to long term returns compared to index funds, explains Bhatnagar.

Reference Link:- https://www.business-standard.com/amp/finance/personal-finance/what-are-index-funds-why-have-they-become-popular-how-to-pick-right-one-123080900091_1.html
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