Mutual fund investing can be done in two ways. One is the active style of investing where a fund manager fishes for the best stocks to buy and hold and generate profits for the investors. As you can imagine, this requires expertise, time and tools all of which cost a lot of money to the investors. The other is the more boring style called passive investing where a mutual fund can simply track a benchmark index. This is the approach followed by index funds. But should I invest in index funds in India at all ?
How do Index Funds work ?
Index funds try to ape a benchmark index by investing in only those stocks that the benchmark holds. Since the benchmark has a lot of stocks and each stock has some percentage in the total portfolio, the portfolio of an index fund is also allocated in the same way as the benchmark.
To explain with an example, the BSE Sensex has 30 stocks in it and each of those have some percentage space. A mutual fund created to track the Sensex and having the same stocks in the same proportion as BSE Sensex will qualify to be called an index fund.
Similarly, you can have index funds that track the Nifty or for that matter the other indexes we have.
Advantages of Index Fund Investing
If you ask, should i invest in index funds, the following are the advantages of index funds.
- They are very easy to understand : If you know the 30 stocks of the Sensex, you know exactly what the constituents of your index mutual fund tracking the Sensex is. With actively managed funds, this is a challenge as the constituents keep changing every now and then.
- Their returns are always in line with the benchmark index : So as compared to actively managed funds where a fund manager is working consistently to generate returns for you, the probability of going wrong with investment decisions is less. If the benchmark generates less returns, you get less and if it returns more, you get more.
- Their costs are lower : Since the investment style is passive, index mutual funds do not have higher fees for trade analysts and fund managers – there is less churning !
Tracking Error
Should i invest in index funds – While index funds are meant to track a benchmark index to the last bit, actually they don’t. Many funds end up tweaking the percentage allocation of holdings of the stocks.
Naturally, when you do that, the index fund’s composition is no longer same as the benchmark and if that is the case, the returns will also be different. Because of the changed composition, trading costs and fund management charges also vary.
Because of the above, the difference in return between the benchmark and the index fund is called tracking error.
The less the tracking error the better it is. 
Index Funds are Meant for-
Simply put, index funds are for the laid back investor. For beginners who have just started doing their financial planning and learning about investment avenues, these can be a good stepping stone.
Does that mean that they are not meant to find a place in everyone’s portfolio ? Well, if you go by the book a “A random walk down Wall street”, you will be convinced they need to be in your portfolio. But the issue really is that the logic holds a lot of ground in Unites States. In India, index funds paint a different picture.
Though their costs, measured by something called expense ratios, are comparatively less, they have not managed to generate returns more than actively managed mutual funds. There are some which actually generated less than their benchmark !
The expense ratio of such funds vary from 0.25% to 1.5%. Now 1.5% is huge ! I would not want to pay such a huge expense ratio and expect meager returns.
If you cast a quick eye on the returns of such funds from the table below (Options in India), you will realize that only one fund, HDFC Index Fund has given more than 15% returns and then you have a handful of them at around 11.00%. But look at the screenshot below which shows that all kinds of actively managed equity funds have given a minimum of 12.60% in the last 3 years.
Now with that kind of return difference, I don’t want to even compare the expense ratios as it is a done decision.
So, should i invest in index funds? I think actively managed mutual funds are a better option !
Equity Mutual Fund returns for last 3 Years – Source ValueResearchOnline
Should I invest in Index Funds – Options in India
Here are the list of such mutual funds in India. The 3 year, 1 year, 6 month, 3 month and 1 month returns are indicated as well. Take your pick.
| Rank | Scheme Name | Performance of Index Funds in India | ||||
| 1 Mth % | 3 Mths % | 6 Mths % | 1 Yr % | 3 Yrs % | ||
| 1 | HDFC Index Fund – Sensex Plus Plan | -3.80 | -3.25 | -3.10 | -5.82 | 15.64 |
| 2 | IDFC Nifty Fund – Growth | -4.43 | -4.33 | -3.64 | -6.34 | N/A |
| 3 | Reliance Index Fund – Nifty Plan – Growth | -4.56 | -4.57 | -3.70 | -7.29 | N/A |
| 4 | ICICI Prudential Index Fund | -4.40 | -4.76 | -4.23 | -7.54 | 11.97 |
| 5 | LIC Nomura MF Index Fund – Nifty Plan – Growth | -4.46 | -4.59 | -3.95 | -7.57 | 10.74 |
| 6 | Tata Index Fund – Nifty Plan – Option A | -4.51 | -4.45 | -3.96 | -7.75 | 11.34 |
| 7 | PRINCIPAL Index Fund – Growth | -4.59 | -4.71 | -4.05 | -7.80 | 11.35 |
| 8 | Canara Robeco Nifty Index – Growth | -4.54 | -4.77 | -4.17 | -7.84 | 11.41 |
| 9 | SBI Magnum Index Fund – Growth | -4.56 | -4.76 | -4.30 | -7.96 | 11.43 |
| 10 | Tata Index Fund – Sensex Plan – Option B | -3.74 | -4.36 | -4.17 | -8.09 | 8.04 |
| 11 | Franklin India Index Fund – NSE Nifty Plan – Growth | -4.55 | -4.99 | -4.38 | -8.13 | 11.53 |
| 12 | ICICI Prudential Nifty Junior Index Fund – Growth | -6.47 | -1.09 | -2.44 | -8.19 | N/A |
| 13 | IDBI Nifty Index Fund – Growth | -4.58 | -4.80 | -4.32 | -8.35 | N/A |
| 14 | UTI Nifty Fund – Growth | -4.55 | -4.82 | -4.31 | -8.37 | 11.10 |
| 15 | Birla Sun Life Index Fund – Growth | -4.61 | -4.95 | -4.59 | -8.59 | 10.75 |
| 16 | LIC Nomura MF Index Fund – Sensex Advantage Plan – Growth | -4.29 | -4.53 | -4.11 | -8.60 | 11.58 |
| 17 | LIC Nomura MF Index Fund – Sensex Plan – Growth | -3.78 | -4.51 | -4.43 | -8.60 | 10.78 |
| 18 | HDFC Index Fund – Sensex Plan | -3.81 | -4.57 | -4.40 | -8.71 | 10.71 |
| 19 | IDBI Nifty Junior Index Fund – Growth | -6.70 | -1.02 | -2.69 | -8.78 | N/A |
| 20 | Tata Index Fund – Sensex Plan – Option A | -3.80 | -4.54 | -4.53 | -8.80 | 11.14 |
| 21 | HDFC Index Fund – Nifty Plan | -4.50 | -5.09 | -4.63 | -8.81 | 10.19 |
| 22 | Franklin India Index Fund – BSE Sensex Plan – Growth | -3.84 | -4.80 | -4.79 | -8.86 | 11.45 |
| 23 | Reliance Index Fund – Sensex Plan – Growth | -3.76 | -4.36 | -4.26 | -8.93 | N/A |
| 24 | Goldman Sachs S&P CNX 500 Fund – Growth | -5.06 | -3.51 | -4.07 | -9.00 | 11.53 |
| 25 | Taurus Nifty Index Fund – Growth | -4.49 | -4.72 | -5.56 | -9.83 | N/A |
| *Note:- Returns calculated for less than 1 year are Absolute returns and returns calculated for more than 1 year are compounded annualized. | ||||||
Source – mutualfundsindia.com
Do you hold any? Should I invest in index funds – Now you know the answer!
Enjoyed reading it. Well written and good stuff no doubt.
Good Analysis, I personally don’t invest in index funds but it’s good for people who have very little knowledge of MF. In the chart of performance of index funds in India it would have been good to have a column with Sensex returns, this way we could compare easily.
Should be a cakewalk to get the returns of Sensex for the last 3 years which is what this table shows for all the index funds.
I believe that even for non ‘laid back’ investors, having Index funds in the portfolio can be a good decision. This article has forced me to rethink my investment strategy. Generally Equity as an asset class is a high risk sector. Even within equity funds, different fund categories have different levels of risk. For example, a Large Cap fund is of lesser risk compared to MidCap. Sector is more risky than Equity Diversified.
If for an investor who wants to have an exposure into Equity, but has a very little risk appetite, I think Index fund is the way to go as :
1. It is well diversified – considering it mirrors an index;
2. Mostly would be a large cap – considering only NIFTY Funds;
3. Low cost – compared to actively managed funds;
4. Easy to choose – tracking error vs. annual cost decision.
What would you think about it ?
Regards
BanyanFA
Had the expense ratios been a bit lower, I guess this would have been good for non laid back investors as well.
You are right about the fact that an investor who has less risk appetite but wants exposure into equity should go for index funds.
The 4 factors you list are good as well, only point 3 is a bit of a mess, the low cost could be lower !
Not sure why a non-laid back investor choose index funds. If you have to choose between HDFC Index and HDFC Top 200/Equity, it would make sense to go with the latter if your horizon is long term.
Rakesh, index funds are not bad – in fact, in the US extensive studies have been done to prove the fact that index funds score over diversified equity mutual funds as far as returns are concerned.
I also know for sure that groups like MoneyLife propagate index funds majorly in a investor’s portfolio. Even for a non laid back investors index funds can find a pace in the portfolio but the case becomes weak in a market like India where their expense rations are higher and equivalent to equity diversified MFs.
@TheWealthWisher,
I know what you are saying, In US index funds have beaten Eq. diversified funds but in India its other way around. Most of the fund managers of Index funds are not as aggressive as their Eq. diversified counterparts. I am not against investing in index funds but if your investment duration is long term then it would be better to go with good performing EQ. diversified funds, thats my view.
@ Rakesh,
I think, the best way to approach Index funds is looking them from a Risk perspective. I hope you all would agree that if you have a very high risk aptitude, you may want to go for just sector / small & mid cap funds. Index funds are a perfect suit for investors having medium / low risk requirement. What a Gold fund vs Gold ETF, same may be an Index fund vs Index ETF.
It is even a good option for investors who want to actively trade in MFs. It is easier to punt / sell / buy index funds as their returns would be closely mirroring the Index. However in case of an actively managed fund, the fund manager’s hedging tactics may not allow a successful speculation.
Very good point made by BFA. Thanks for your comments.
That is true Rakesh, I do agree with you on this.
If someone wants to invest in indexes, can’t they buy it directly like people invest in sensex? Why pay extra to manage the index MF?
Vivek,
Best way to invest in Sensex / Nifty is via ETFs. However, ETFs come with their own limitations such as demat accounts, requiring a Broker, etc. Check out http://insight.banyanfa.com/?p=635 which details on ETF’s mode of operation.
However, Index funds may act as a bit simpler instrument whereby the investors can trade in an Index without an ETF / or more dangerous Derivative products such as F&O. I do understand the exit load criterias which hit Index funds, but hey, if you buy and sell an ETF, you end up paying over 1% in terms of Brokerage, Demat charges, etc.
Regards
BanyanFA
F&O, BFA – do you really trade in F&O – is it required ?
Your point makes sense. It is not easy for a novice to get into demat account and manage expenses and all.
But still even for a laid back investor I’d suggest to invest in diversified equity MFs or even debt funds for that matter if you have low risk appetite. These index funds don’t make much sense to me from investment perspective.
How would a laid back investor track a diversified equity MFs he invested in ? He is laid back so cannot monitor. If MF can easily go down in performance.
In such a case, index MFs make sense.
Are you saying index funds don’t need to be monitored at all?
When a person buys an index fund, he ought to have accepted that his returns are in line with the Sensex or Nifty or the benchmark in question. So the monitoring is useless if he knows what the benachmark is returning.
Monitoring is needed as return of the investment is required to guage the impact to overall portfolio.
But index funds do not need monitoring as much as a diversified equity MF would.
Sorry did not understand your question – if you meant why they can’t buy stocks of the index in the same proportion as it exists, then yes they can. They only issue is, the person ill have to actively manage the proportion as it changes on the fly. Quite a task I think !
Yep, you got it right. It is either that or via ETFs.
If I’ve to opt between ICICI PRU. TECHNOLOGY and ICICI PRU FMCG, which should should I go for? Your advice please.
@Chandan,
What’s your rational in selecting Technology and FMCG fund, have your tracked their performance? Why not stick to better performing funds namely HDFC Top 200, DSP Top 100, IDFC Premier Eq. fund….
LOL ! These are sector funds, one should go for them when one is having enough diversified ones in the first place. Assuming that this the case, FMCG is a defensive cyclical sector and will return less than technology according to my reading.
OK…got it.
Yes, Active Funds do have higher expenses, but they also have consistently delivered higher returns.
Give me fund which delivers higher returns with higher costs any day over the fund which delivers lower returns with lower costs.