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Index Funds: the good, the bad, and the variety

This is Part 2 of our special series on index funds, in which we will talk about the kind of index funds that are available to Indian investors as well as the pros and cons of index funds. And if you haven’t read the first part of this series in which we explain what they are, what experts say about them and how they differ from other kinds of mutual funds, here it is: ‘Index Funds. A good fit for you?’

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While the definition of an index fund is relatively straightforward (and we covered this in the previous blog), there are still several dimensions on which index funds can vary.

As a result, there are various flavours of index funds, each potentially playing their own different roles in your portfolio.

Some of the most important types of index funds available to Indian investors are:

1. Broad market-based Index Funds

These try to replicate a large segment or a wide range of the market. They invest in stocks across different sectors and market capitalisations and hence tend to portray the total performance of the stock market. A Nifty 500-based index fund is an example of this type.

2. Market capitalization-based Index Funds

A market-cap based index fund gives higher weightage to stocks with a higher market capitalization. Indices such as Sensex or Nifty 50 are market-cap weighted and are highly popular in India.

3. Equal Weight Index Funds

In an equal-weighted index fund, every stock in the chosen Index will carry the same weight. For instance, if the underlying Index is Nifty 50, all the 50 companies in the corresponding equal-weight Nifty 50 index fund will have an equal weightage (of around 2%).

4. International Index Funds

These funds offer investing opportunities in stocks of companies listed outside of India, providing Indian investors exposure to global markets. These can track multiple US-specific indices like S&P 500, NASDAQ, NYSE FANG+ Index, among others.

5. Factor-based or Smart beta Index Funds

These are a unique type of index funds that apply certain filters or selection criteria (known as factors) on top of an underlying index. Their goal is to be smarter than vanilla indices- trying to outperform the underlying index by using filters to separate the higher potential companies from the average ones.

6. Debt Index Funds

These are based on indices comprising only debt instruments such as corporate debt securities or government debt securities. Such funds are meant for those whose goal is less to do with growing wealth but more to do with beating bank savings rates and earning more tax-efficient returns while adding a sense of stability to their portfolio.

Key benefits and drawbacks of index funds?

Alright, so what we’ve seen so far is that several well-respected global investors swear by index funds, and that Indian investors can pick and choose among several varieties of index funds, depending on their convictions and investing style.

But what benefits do these funds offer that makes them so attractive in the first place? And what kinds of drawbacks are associated with them?

The main benefits of Index Funds

1. Lower costs can mean higher gains

Fund management involves several different kinds of expenses. Since index funds are passively-managed funds, expenses to manage them are typically much lower than those for actively managed funds. Think no active fund management analysis, no large analyst teams, no daily tracking or buying/selling decisions. These savings get passed on to investors in the form of lower fees (expense ratios), and then can compound over time into considerable additional sums.

2. Transparency

In addition, index funds are very transparent products, since investors will always know what their composition is, as there will be no difference between their holdings and that of the underlying index.

3. Good potential long-term performance

Index funds that track a broader market index can help investors take advantage of the market’s long-term growth without the hassle of needing to choose the right funds or the best fund managers. For instance, the Nifty 50 grew 14x during the 25-year period between its inception in 1996 till about 2021.

As we’ve already established by now, a broad market index fund matches the market in terms of growth, while actively managed funds aim to beat the market. Thus, investors who would prefer not missing out on whatever the market delivers would do well to invest in index funds- as these funds come without the excitement of outperformance or the pain of underperformance that comes with active funds.

4. Good diversification 

For those just starting out in the world of investing, selecting the right companies to invest in, is a difficult task. With thousands of stocks listed and available to invest in, how can you choose the right stock that carries good potential to outperform with a relatively lower risk of failing? If you’re not an expert or this is not your full-time job, this can be exceptionally taxing and difficult- even the best in the business make many mistakes.

Therefore, buying an index fund can be a great first option for those who want to make money from the market but are not willing or able to do the hard yards needed to get there. Given that most index funds are diversified due to the multiple instruments present within their underlying indices, investors automatically get the benefit of diversification- thereby reducing the risk of failure.

Two drawbacks of index funds

1. No outperformance to benefit from

By definition, index funds cannot outperform the market or segment they track. This means that index fund investors lose out on any outperformance that an actively managed fund might be able to generate, especially in rising markets. Of course this comes bundled with the benefit of no underperformance either, but those seeking higher than index returns all the time are likely to be disappointed.

2. Tracking errors can reduce net returns

Since index fund compositions can’t be changed instantaneously when the underlying index’s composition changes, there is a discrepancy between an index fund’s returns and those of the underlying index. This discrepancy is called the tracking error, and it effectively represents a lowering of the fund’s net rate of return. We wrote about this concept in detail in another blog, do give it a read too.

So now that you’re much more familiar with the main types of index funds and their pros and cons, the next step is to examine how you should approach them as an investor.

Interested in considering index funds for your own portfolio? Look at some of our offerings by clicking below.

Stay posted for Part 3, where we round this series off with a discussion on the kinds of investors who should invest in index funds. In addition, we will also examine how you should select an index fund.

 

Disclaimer

This note is for information purposes only. In this material DSP Investment Managers Pvt Ltd (the AMC) has used information that is publicly available and is believed to be from reliable sources. While utmost care has been exercised, the author or the AMC does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers, before acting on any information herein should make their own investigation & seek appropriate professional advice. Any sector(s)/ stock(s)/ issuer(s) mentioned do not constitute any recommendation and the AMC may or may not have any future position in these. All opinions/ figures/ charts/ graphs are as on date of publishing (or as at mentioned date) and are subject to change without notice. Any logos used may be trademarks™ or registered® trademarks of their respective holders, our usage does not imply any affiliation with or endorsement by them.

Past performance may or may not be sustained in the future and should not be used as a basis for comparison with other investments.

Mutual fund investments are subject to market risks, read all scheme related documents carefully.

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