Your Money: Index funds – Made for turbulent times | The Financial Express

Your Money: Index funds – Made for turbulent times

Investors seeking at least market returns without much intervention can consider index funds

Your Money: Index funds – Made for turbulent times
In this context, let us discuss an interesting and often neglected fund, namely index funds and their nuances.

As per the recent AMFI monthly report, mutual funds have now touched Rs 37.76 trillion mark in terms of Asset Under Management (AUM) and offer all almost all type of asset classes with a wide range of equity, debt, money market, hybrid, growth, income, index, liquid, tax-savings, capital protection, fixed maturity, pension, aggressive, etc., covering across all risk and return grades. However, with this huge diversity comes the complexity of decision making. In this context, let us discuss an interesting and often neglected fund, namely index funds and their nuances.

What are index funds?
Index funds are those mutual funds that simply replicate an index like (Nifty 50 or BSE 30) in its portfolio to the last cent. As there is no human intervention in the management of these funds, they are popularly known as ‘passive funds’ or ‘index funds’. Developed markets like the US have already witnessed a massive shift towards index-oriented investing, in India also index funds started picking up recently owing to the digital platforms, media and analysts have enhanced the awareness of such funds and performance of such funds are available in public space.

Also Read: Your queries: Mutual Funds – Below-average performance for 2-3 years? Switch your fund

Conviction and consistency
The basic conviction on which passive investing thrives is based on the efficient market hypothesis wherein in any efficient market, new information comes to the market in a random fashion, and it gets reflected immediately in the share prices. This means that fund managers would find it more challenging to beat the benchmark index and a positive alpha become more elusive. Investors can observe that in the recent years (three to five years period) the index fund approach is delivering much better returns than of traditional mutual funds. In the year 2022, activity funds find it difficult to tackle issues such as inflation, interest rates, global recession, geopolitical issues, etc.

How index funds are scoring?
The major reason for index funds’ consistently better returns is their lower costs as well as discipline. Though index funds have professional fund managers, they are not paid more for their expertise in stock selection and sector allocations. They follow the rule of natural selection — stocks that do well stay in the index and others drop out. This way the index itself does the work of stock selection for the fund manager.

Actively managed funds take into account costs of an expert team, research analysts, time taken to hand-pick stocks, etc. which ultimately increase their expense ratios. Further, passive index funds avoid any human emotion or errors as wisdom of crowds or market performance get built in decision making. The average expense ratio of actively large cap mutual funds (direct plans) is 1.06% to 2.25% whereas the expense ratio of the same category of index funds is 0.25% for direct and 0.65% for regular plans.

Other advantages
Another major advantage of an index fund is that it is based on a diversified benchmark like Nifty 50 index which itself contains a pre-selected diversified holding of shares across a wider sector and industries. All the information that an investor may need about the fund’s basket of stock is readily available, so one could know at any point of time where the money is invested. As there is no active involvement by the fund manager, there is little room for human error or biases which could affect the fund’s performance. Thus, this helps to minimise emotional investor behaviours like herd mentality, timing the market or stock selection bias.

To conclude, while the debate between active and passive investing is an old one, the bottom line is that both have their place according to the risk profile of the investors. However, for investors seeking at least market returns, without much intervention over a longer period, and new investors who have confusion on selecting the right fund, could consider index funds as their best choice.

The writer is a professor of finance & accounting at IIM Tiruchirappalli

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First published on: 10-10-2022 at 01:00 IST