In India, Index funds are yet to gain popularity simply because active mutual funds have been able to beat the markets consistently.

In an interview last year, Warren Buffet had said that he had advised his wife to invest all the money in index funds after his death. And why not so? It is the simplest way to multiply your money in few years.

Index funds are safe haven for pensioners who are risk averse but at the same time seek certain amount equity exposure.

But what are index funds?

The target here is not to beat the stock markets like actively managed mutual funds but to replicate the indices. It gives advantages like lower maintenance and bigger exposure to markets and more or less safe returns.

Let’s take an example: Suppose a vegetable vendor instead of buying broccoli and mushroom (which are in demand) with all his money, obtains certain amount of potato, tomato, onion, cauliflower, and also broccoli and mushroom in the same ratio available in the wholesale markets. Though the demand for broccoli and mushroom are high and can be sold at a higher price, the later arrangement holds a lesser amount of risk as there might be customers who would be looking for potatoes and tomatoes also.

Similarly, an index fund portfolio that follows a particular index will have all its stocks in the same ratio. Here, the fund managers simply looking at the performance of the index decides which stock to sell and which one to buy depending upon the rise and fall of prices.

One point to note here is index funds is a sum average of a particular index & hence offers average return.

Index funds v/s mutual funds

This passive aggressive investment instrument is widely popular in the developed markets where actively managed mutual funds often fail to beat the markets. The primary reason for this is fund manager fees -about two to three per cent is cut from the entire revenue as the fund manager’s fee and operation charges.

Meanwhile in case of index fund you are betting the money on the entire economy, so your money will grow as and when the index grows. Here, the fund manager’s fee is about .5 to .7 per cent because all they have to do is to reduce the tracking error. Now what is a tracking error?

For example, if the S&P 500 which is  most widely tracked by various index funds had given 10 per cent return in a particular span and in that same span, a particular index gave 9 per cent return, then this difference of one per cent is the tracking error. There are several factors that lead to tracking errors that include fee cut, timely buying of funds, algorithm etc.

The India play

Popularity of index fund is yet to pick up in India as compared to the developed markets due to following reasons:

First, in India equity exposure is only three per cent as against about 34 per cent in the developed market. Hence, the mutual funds have wide arena to play. Moreover, before Security and Exchange Board of India (SEBI) came with a strong directive dated October 2018 (which will come back to later), there was no strict adherence to the holding limits with respect to small, medium and large stocks. The definition of small, medium and large cap stocks used to differ from one fund manager of one AMC to that of another fund manager of a different AMC. Sometimes two different fund managers of the same AMC used to follow different holding limits. As the earlier regime was full of ambiguity we witnessed buying across the board. This was the main reason for the buoyancy in the small and mid-cap stocks we witnessed during 2016-’17 leading to mutual funds regularly beating the markets.

Second, unlike the European and the US markets where index fund is already popular, in India it has been recently introduced so these funds don’t cover the entire market or economy. Moreover, many of the well know Indian companies are listed outside the country. However, SEBI (Security & Exchange Board Of India) with the intent to bring transparency into the mutual fund sector has come out with few strict directives that will change the mutual fund landscape forever.

As per its directive dated October 2018, all mutual fund schemes including large mid and small cap companies have been redefined as per their market capitalization. And the board has asked AMCs to strictly follow the standardization of holdings.  Now for the fund managers it is mandatory to invest 80 per cent of the corpus in the large cap stocks and rest of the 20 per cent can be invested either in mid-cap or small cap or in combination of both. This move however will make the transactions safer but the returns will be further less.

Hence, it will be beneficial to invest in Indian index funds only if you are thinking long-term like 10 to 15 years. The market experts predict the industry will be booming by then.

So at this moment you can safely add an index funds to your portfolio along with your mutual funds and other safer products like fixed deposits, bonds, PPF and gold. However for choosing the right investment you have to look for the funds which have the least tracking error.

Stay Invested!