Over the last few years, the voices calling for investment in index funds are progressively getting louder. In many categories, especially in the equity large-cap space, the opportunities to generate alpha are getting slimmer. In such a scenario, many investors are showing a proclivity towards passively managed funds that can generate benchmark returns without the additional cost.
Index funds are simply mutual fund schemes whose portfolios are designed to mimic the underlying index. This means that the index fund’s composition is the same as the composition of the underlying index with the assets being held in the same proportion. In India, many of the index funds use either the Nifty or the Sensex as the base to construct their portfolio.
Index funds passively track the performance of a particular index. Contrary to actively-managed funds, index funds do not have a mandate to outperform the benchmark. They just need to mimic the performance of the underlying index. Since the index fund tracks an underlying index, it is passively managed and consequently, the cost of managing the fund is relatively lower. Generally, index funds have an expense ratio of 0.5% or even less which is significantly lower than the average expense of 1 per cent to 2.5 per cent charged by actively managed funds. If two index funds are tracking the same underlying index then both are likely to generate the same returns. If there is a difference, then it will stem from a difference in cost and tracking error. Investors looking to invest in index funds should pay attention to the tracking error of the fund. The tracking error measures the deviation of fund return from the returns of the benchmark that it is tracking. The lower the tracking error, the better the fund’s performance.
In order to build robust long-term portfolios that can weather the short-term asset price volatility, it is important that investors optimally diversify their portfolios. This means that investors must invest across multiple asset classes and also evaluate within asset class diversification. Index funds can be a good tool for providing portfolio diversification at a relatively lower cost. Additionally, since they are passively managed, investors need not constantly track the performance of the index fund. The key thing to remember here is that these funds will not give you above average returns and depending on the underlying index, they can carry varying levels of risk. Thus, investment in index funds should be evaluated judiciously and executed from an overall portfolio perspective.