Pros and Cons of investing in Index Funds

Case for investing in index funds in India

As per SPIVA reports, many active funds have underperformed their benchmark in the last couple of years. The underperformance is higher in the case of active large-cap mutual funds. Active mid and small-cap mutual funds have performed reasonably better than their benchmark. The underperformance by active mutual fund schemes, specifically large-cap funds, makes a case for investing in index funds in India.

What are index funds?

An index fund is an open-ended mutual fund scheme replicating or tracking a specific index. It has to invest a minimum of 95% of its total assets in the securities of a particular index that it is replicating or tracking.

For example, a Nifty 50 index fund has to invest its money in all the 50 constituents of the Nifty 50 Index as per their weightage in the Nifty 50 Index. Similarly, a Nifty Next 50 index fund has to invest its money in all the 50 constituents of the Nifty Next 50 Index as per their weightage in the Nifty Next 50 Index.

The objective of an index fund is to mirror the benchmark index as closely as possible and not to outperform it.

Pros of investing in index funds in India

There are many benefits of investing in index funds in India. Some of these include the following:

• Low cost

The biggest benefit of investing in index funds is the low cost. Most active mutual fund schemes have an expense ratio of 1.00% to 2.25%. Whereas in the case of index funds, the expense ratio is usually between 0.05% to 1.00%. The difference of 0.50% to 1.00% in the expense ratio between active funds and index funds may seem small, but over a period of time, it can lead to a big difference in the corpus accumulated. A higher expense ratio directly reduces the net returns of an investor. As the index funds have a lower expense ratio, the difference between the benchmark returns and index fund returns will be low.

• Diversification

An index fund gives you the benefit of diversification at a low cost. For example, the Nifty 50 Index comprises India’s 50 best companies in various sectors such as IT, oil and gas, steel, FMCG, banking, healthcare, automobiles, infrastructure, power, telecom, etc. When you invest in a Nifty 50 index fund, you automatically get exposure to companies in these sectors. So, you automatically get a well-diversified investment portfolio when you invest in a Nifty 50 index fund.

• Removal of fund manager bias

When you invest in an active fund, the fund manager takes the buy and sell decisions. The fund manager decides which stocks to buy, how much quantity, when to buy, and what price to buy. Similarly, at the time of selling also, the fund manager takes the decision. The fund manager decides which stocks to sell, how much quantity, when to sell, and what price to sell. So, in an active fund, all buy and sell decisions are influenced by fund manager bias, although all decisions are backed by research and data.

However, in an index fund, the fund manager has no say in the buying and selling decisions. The fund manager has to invest in all the index constituents as per their weightage in the index. Similarly, whenever the index is reconstituted, and some stocks are removed from the index, the fund manager has to sell those stocks. So, index fund investing is completely free from fund manager bias.

• Easy to manage

Investments in index funds are easy to manage. You can get exposure to India’s top 500 companies by investing in just four index funds. These include one Nifty 50 index fund, one Nifty Next 50 index fund, one Nifty Midcap 150 index fund, and one Nifty Smallcap 250 index fund. Also, such an investment portfolio of just four index funds will have a zero overlap among the four funds. Hence, investments in index funds are easier to manage than active funds.

• Taxed as equity funds

Index funds invest a minimum of 95% of their assets in the equity shares of companies that are a part of the benchmark index. Hence, index funds are categorized as equity funds from a taxation point of view. Taxation of equity funds is more favorable than that of debt funds.

Cons of investing in index funds in India

While there are many benefits of investing in index funds, there are some cons also. Some of the cons of investing in index funds include the following:

• No choice for selection of stocks or sectors

In the earlier section, we have seen that an index fund manager has to invest in all the benchmark index constituents. The index fund manager may not like a specific company or feel that a certain sector will not do well going ahead. But, still, the index fund manager will not be able to avoid investing in a specific company or sector. But, that is how index funds have been designed. Some investors look at this as an advantage wherein they automatically get a diversified investment portfolio. But, some investors look at this as a disadvantage as it limits selecting stocks or sectors.

• Tracking error

The benchmark index and index fund returns may not match exactly. The difference between them is known as the tracking error. The tracking error is due to expense ratio and other factors. When investing in an index fund, the lower the tracking error, the better. While investing in an index fund, you should compare funds in the same category and ideally invest in an index fund with the lowest tracking error.

Index funds in India for investment

Some of the index funds that you can invest in include:

Investing in index funds

We have discussed the various pros and cons of investing in index funds. The pros outweigh the cons. To benefit from low costs, diversification, easy management, and favorable taxation, you should consider investing in index funds.