Index fund investing and its actual benefits

Index Funds are big business in other parts of the world but in India, they have hardly taken off. The reasons are not very hard to seek. In India, the opportunities for alpha are so many that fund managers hardly found the need to push index funds as an asset class. For example, in a country like India, nearly 80% of the fund managers outperform the index whereas in other countries it is less than 20%. So, if you invest in equity funds with a reasonable level of due diligence, then you stand a very high chance of outperforming the market. But index funds offer you market type performance with very limited market risk. Let us focus on how index fund as a form of passive investing can add value to investors?

referal plan Index fund investing and its actual benefits

Index Funds as a form of passive investing

Index funds are the ultimate example of passive investing. Let us understand passive investing as opposed to active investing. Inactive investing, the fund manager has the discretion to buy and sell stocks so as to enhance returns for the fund holders. Diversified equity funds are examples of active funds. An index fund, on the other hand, purely invests in the index. That means it buys up all the stocks in the Nifty or the Sensex in the same proportion as it is featured in the index. It is only when index weights change or when stocks are added or deleted from the index that the index fund manager modifies the index fund portfolio. An index fund is intended just to replicate the index returns as close as possible. After all, the Sensex has grown from 100 in 1981 to 38,000 in 2018, which is an amazing growth story. So index investing is not so bad after all!

What are the benefits of index fund investing?

  • An index fund will not outperform the index but will be on par with the index. As we saw earlier, that is not really bad. It can still promise you good returns over a longer time horizon. The Sensex has a base value of 100 in 1981 and over the last 39 years, it has given 38-fold returns. The Nifty has its base in the year 1995 and has given 11.50-fold returns over the last 23 years. That means you can get the benefit of equities via an index fund without taking on too much of stock specific risk.
  • The big advantage of Index funds is that it overcomes the bias of fund manager discretion. Fund managers are humans after all and so human discretion is part of their job. That is the problem with most diversified equity funds. There is a strong element of discretion that is available to the fund manager. As a result, the fund manager’s conditioning, biases, preferences, predilections and past experiences influence the investment strategy of the fund in a very big way. The index fund, being a passive fund, has no room for such biases.
  • The big advantage could be the cost factor. Costs in an index fund are substantially lower. For example, an index fund would have a TER of around 1.2% while the equity diversified fund will have a TER of 2.5%. This makes a huge difference over the longer time frame. In the 2017 annual general meeting of Berkshire Hathaway, Warren Buffett had lauded the efforts of John Bogle, the founder of Vanguard Funds. Vanguard is one of the world’s largest asset managers with over $4.50 trillion in AUM. Buffett pointed out that Vanguard saved billions of dollars in costs to mutual fund investors by adopting an index-based strategy, which is a lower-cost strategy.
  • Index funds are more transparent in their intent. Many diversified funds are actually index funds with minor tweaks since a major proportion of their portfolio is invested in index heavyweights. Therefore, you end up paying a higher Total Expense Ratio (TER) for marginal return benefits. Index funds help you to overcome this challenge. In India, Index funds have actually performed reasonably well if you consider their returns net of total expense ratio (TER) costs.
  • As alpha gets harder to generate in the Indian markets, there will be a greater onus on index funds for their passive approach. Why pay high fees to active managers when the additional returns are not justified. Once the index methodology becomes tighter and information flow more efficient, the returns differential between active funds and passive funds will reduce to a much lower spread.

Are there any challenges to index funds?

Of course, there are some downsides to index funds too! For example, active investing works better when the market is too volatile. In such cases, the active manager can increase the cash holdings temporarily. Secondly, index funds are vulnerable to the risk of tracking error. It is the extent to which the index fund does not track the index.

Index funds have not been great performers in the past. Index Funds is surely an idea which may become a lot more attractive in the coming years.

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