With over 5000 companies listed on both the Bombay Stock Exchange and the National Stock Exchange, it is highly difficult for an investor to find and select good stocks for investing, even for some of the most seasoned professionals and investment bankers.
The two most popular methods of managing a mutual fund are, passively managing and actively managing. While managing an active fund, the managers select stocks for investing by the goal of the fund. The fund manager aims to beat the market by selecting over-achieving stocks.
Nonetheless, the returns from active funds completely rely on the efficiency and the investment goal of the fund manager. Also, there are some inherent risks involved in investing in active funds which include inefficient investment decisions made by the fund manager, the risk of the fund manager switching jobs and moving to another company etc.
Passive funds are process driven, i.e. the fund invests in the market indexes, and the fund managers are not required to select stocks for investing. Passive funds do not have the inherent risks involved with active funds such as inefficient investment decisions made by the fund manager or the risk of the fund manager switching jobs and moving to another company etc.
What is an Index?
As there are thousands of companies listed on the Bombay Stock Exchange and the National Stock Exchange, it is not practical to track the performance of every stock listed on the stock exchange towards evaluating the performance of the stock exchange at a given period.
A market index is a smaller sample of some of the high performing stocks listed on the stock exchange. These stocks include companies across different industries to offer a better representation of the entire market.
The Market Index of the Bombay Stock Exchange is known as the Sensex or the BSE30. It is a composition of 30 financially sound and well-established companies listed on the Bombay Stock Exchange. Whereas, Nifty, also referred to as the NIFTY50, is the market index of the National Stock Exchange. It is a composition of 50 financially sound and well-established companies listed on the National Stock Exchange.
While the Sensex and the Nifty are the primary market Index of the Bombay Stock Exchange and the National Stock Exchange, both these Indian stock exchanges have introduced secondary market indexes such as BSE Midcap, BSE Smallcap, Nifty next 50 etc. towards analysing the market performance of a particular segment of stock on the stock exchanges.
What is an Index Fund?
Index funds are passive funds which adopt the investment strategy of offering investors identical returns as the market index the fund is linked with. These index funds attempt to replicate the stock market performance of a selected market index by replicating the stocks and their composition in the particular index within their investment portfolio.
For instance, if an index fund has been benchmarked against the Sensex, it will purchase all 30 stocks within the Sensex Index in the same proportion as in the BSE30. As a result of this, the returns offered by the fund will be similar to the returns offered by the chosen market index.
The HDFC Index Fund – Nifty Plan, UTI Nifty Fund, ICICI Prudential Nifty Next 50 Index Fund, HDFC Index Fund – Sensex Plan – Regular – Growth etc. are some of the examples of popular index funds available in India.
Pros and Cons of Investing in Index Funds in India
Every investment strategy has its share pros and cons, and no investment strategy can be deemed as perfect. Here as some of the pros and cons of investing in Index Funds in India.
Advantages of Investing in Index Funds
- Low Expense Ratio
As index funds are maintained passively, they have a relatively low expense ratio when compared to active funds. The expense ratio of index funds can range between 0.2-1.2%.
- Non-Dependency on the Fund Manager
Index Funds do not rely on their fund managers for selecting stocks for investment and making an investment decision. Investment decisions merely copy their selected indexes. As a result of this, when a fund manager of an index fund quits and switches jobs, it does not create issues for the index fund, unlike in the case of active funds.
- Easy for Investors to understand and Select Funds
While investing in an active fund, the investor needs to carefully read and understand the complicated terms and conditions of the active mutual funds. Whereas, selecting an index fund is almost equivalent to selecting a market index.
Disadvantages of Investing in Index Funds
- Lack of Flexibility for the Fund Manager
The fund manager of an index fund cannot make an investment decision regarding the selection of stocks and making an investment decision. As a result of this, the fund manager cannot invest in stocks having growth potential and with this lose opportunities to outperform the market and deliver high returns to the unitholders.
- Index funds cannot offer Higher Returns than the Market
As the index fund follows the movement of market indexes, it cannot offer higher returns than the market. Furthermore, the returns offered by index funds are lower than the market returns after deduction of expense ratio and other fees.
- Need to Sticking to Poor Performing Stocks
An index fund cannot invest in stocks and shares of companies which are not a part of the index funds, and as a result of this, the index funds have limited investment options. For instance, an index fund investing in the BSE50, the index fund is forced to hold non-performing stocks and cannot sell them as they are a part of the Sensex. q2This is as the index fund tries to keep its investment composition similar to the composition of the share market index regarding market capitalisation.
- An Index Fund invests in risky stocks
In case certain risky stocks or asset class are a component of the market index, the index funds us a force to invest in these risky stocks and assets.
- Error Tracking in Index Funds
In multiple instances, the index fund is unable to perfectly track the movement and composition of the fund and the market index. This could be due to multiple reasons such as the time gap between accepting and investment and buying the stocks, rounding off errors, adjusting dividends etc.
Advantages of Investing in Index Funds
In developed countries such as the United States, United Kingdom etc., Index Funds have outperformed actively managed funds on many occasion. Though the same cannot be said for developing countries in India, where actively managed funds are constantly beating the market.
This is mainly due to the stock market of developed countries being much more efficient and having a broader market index as compared to the stock market and market indexes in developing countries. While the Nifty consists of only 50 companies and the Sensex consist of only 30 companies, the S&P 500 consists of 500 companies listed on the American Stock Exchanges.
Furthermore, the expense ratio in developed countries is much lower than the expense ratio charged by index funds in developing countries. As a result of this, many Indian investors prefer investing in market indexes of developed countries.
The Bottom Line
Investing in Index funds is a good alternative for investors prefer a straight-forward investment approach, without relying on fund managers, signing complicated mutual fund agreements etc. Index funds invest in a pre-defined set of stocks at a low expense ratio. Also, unlike actively managed funds, investors can easily choose and select an index fund they wish to invest in.