What are Index Funds?

All mutual funds investors have one thing in common, they are on a quest to find the best performing fund to invest! How does one find a best performing scheme? Even if you can find ‘the best’ scheme, would it always remain so? Would it be able to perform consistently over your investment horizon? Answer to all these questions is index fund.

Before we go in any details, let us quickly recall what are mutual funds. A mutual fund scheme is an actively managed investment vehicle. There’s a dedicated fund manager to take investment decisions. Fund manager would target to buy or sell right stocks at right time. The objective is to generate alpha, which is the extra return leftover after matching the benchmark returns and recovering scheme expenses.

Now stock markets are kind of a zero-sum game, isn’t it? In simple words, all the mutual fund managers can’t beat the market all the times. If few schemes are doing good, others must be doing bad! Million-dollar question is, how do you know if your scheme or fund manager will do good or bad? And the answer is, no one knows!

What exactly is an index fund?

An index fund is a specific type of mutual fund with a portfolio constituting of stocks present in an index such as Sensex or Nifty. There is no need of active management as the fund merely replicates the index portfolio. Since there is no active management, the expense ratio is usually on a lower side. The returns are in line with index returns. For example, if Sensex grows by 10% in a period, index fund would also target to replicate similar returns. There may be some difference though, which is known as tracking error. Data shows that index funds have beaten many schemes in their segment consistently.

Let’s take an example

ICICI Prudential Nifty Index Fund – Direct is an index fund in large cap category. Here is a screenshot of it’s past performance –

Index Funds
Image courtesy – valueresearchonline.com

Observe the rank of the fund and overall number of funds in the category. You will notice that through any time horizon, the index fund has beaten 15-20 schemes consistently. Many of these schemes would be actively managed funds. Now if a fund manager can’t beat or match the benchmark returns, why should you pay for the expense ratio? What about the opportunity cost, which means the minimum gains you would’ve made if you invested same capital in a better performing active scheme, or an index fund.

Pros and Cons of index funds

Pros

  • Low expense ratio
  • Risk & returns in line with benchmark
  • Well diversified
  • Best for long term investment

Cons

  • Average returns, no alpha

Why index funds?

Index funds make the most sense if you are investing in large cap funds and have a long time horizon of 10+ years. It’s even more sensible since SEBI’s circular in 2017, which mandates large cap schemes to have minimum allocation of 80% in large cap stocks. If an active fund will invest 80% in large cap stocks, and a large cap index fund will invest 100% in large cap stocks, does the expense ratio on active schemes make sense? And would it be possible for fund managers to generate the alpha and justify the expense?

Hence if you are a layman investor who wants to invest in large cap schemes, targets to join the market rather than beating it or getting beaten, and have a long investment horizon, go for index funds.

Author doesn’t recommend any schemes mentioned in the post and it’s for purely illustration purposes. Your feedback, comments and questions are most welcome!