Index Funds: Rising tides to lift all boats?

This is Part 3 of our special series on index funds, in which we will talk about what kind of people can benefit from investing in index funds and how to make a good choice for your portfolio. Read Part 1 and Part 2 if you haven’t read them already.

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Index funds are a good choice of investment for a broad chunk of the investing public. The crazy rise of index funds as a popular investment option is clear, especially if one looks at data over the last half a decade. Let’s take a closer look at these two points, along with some tips on what investors should look out for when picking an index fund today.

Who can consider investing in index funds?

The simple answer? They are suitable for beginners, seasoned veterans, and everyone in between- as long as you know what you value.

If you’re a new investor and don’t have an MF distributor or professional advisor yet, choosing the right stocks or funds for your portfolio can be tricky. Index funds make this process easy for you, as they are not dependent on a fund manager’s unique styles or ideas. Since you don’t have to go through or analyse P&L statements or balance sheets of multiple companies, compare different product types, study fund manager philosophies, choosing index funds means that the complexity level behind your decisions can reduce significantly.

If you’re a relatively experienced trader/ investor but have struggled to make money from the stock market, Index funds offer an easy, convenient way to begin building a diversified portfolio while still earning market returns. By not getting paralyzed due to uncertainty about how markets might move or knowing what to do next with your money, you will at least be able to stay in the game and earn returns that match the index, which means you’ll not miss out on the market itself!

And if you’re a seasoned investor who already has an existing portfolio of active funds, index funds offer multiple advantages:

- They help reduce costs due to having lower expense ratios (more on this below).

- In the short term, during market slumps, their performance can be better than that of active funds. The converse is also true, however: active funds can outperform index funds when markets rise.

- They can give you easy, hassle-free access specific themes or ideas. For instance, if you want an index fund related to the banking sector, you can choose any banking index that any AMC offers, as all of them are likely to be quite similar. Or for that matter a fund that gives you access to leading US Tech companies, for example a Nasdaq 100 based index fund.

This means whether you’re a newbie looking to make an entry into the investing world, or have 8-10 years+ experience investing or for that matter are a HNI or UHNI looking to reduce costs so the gains you make can increase, index funds offer a powerful alternative way of adding strength to your core portfolio. Which is why we say, #FlexWithIndex!

On the other side- if all you’re concerned about is getting the maximum returns possible (albeit with a relatively low probability of this happening) or investing in a fund or fund manager whose unique stock picking ability or investment philosophy resonates with you, then index funds might not be right for you.

How to select an index fund?

Picking an index fund to invest in might seem like a straightforward decision: after all, most similarly-themed index funds in the market are likely to give you the same returns, right? That’s true for the most part, but there are two key factors you need to keep in mind:

1. Expense ratio: The lower the expense ratio (or the cost of managing a fund from an AMC’s standpoint), the higher the effective returns earned by the portfolio. So when you see similar funds, funds with lower expense ratios can be preferred.

2. Tracking error: The lower the tracking error (or the deviation between a fund’s returns from that of its benchmark index measured over different periods), the better job the team behind that index fund is doing in helping it stay true-to-label. Hence, all other things being equal, choose a fund with a lower tracking error.

Fun fact: a fund’s expense ratio is also accounted for under Tracking Error, so this can serve as the sole parameter to consider when comparing different index funds. More on this here.

Popular and how!

Investors around the world have long known and those in India are recognizing that index funds are a sensible, no-nonsense, no-bias choice that encourages you to stay in, and earn from the market. They also understand that index funds help you avoid excessive decision-making that could hurt your investment outcomes.

Experts are recommending them a lot more these days, and cost-sensitive investors are becoming increasingly aware that index funds can form the very core of your portfolio, instead of playing a peripheral role.

It should come as no surprise then that in just over the last 5 years (between Jan 2017 and Sep 2022), the amount of money retail investors have invested in index funds has risen from less than Rs 1,000 crore to ~Rs 55,000 crore, a 55X+ jump according to data from the Association of Mutual Funds in India (AMFI)!

A new direction?

Our verdict is quite clear: Index funds are a great pick for most investors and deserve more space in most portfolios. They may not replace active funds that are meant to outperform the index, but can certainly add strength to your portfolio, without you having to grapple with too many technicalities or complications. What’s not to love?

If this has gotten you interested in looking at index funds for your own portfolio, do take a look at some of our offerings by clicking below.