What is Index Investing and Index Funds?

The percentage of index funds in my mutual fund portfolio has substantially grown over the years. This was initially because of consistently good performance of index funds but have evolved into a solid strategy, as I keep founding more reasons in favor of this. The same has been the situation with people known to me personally.

Index investing if done properly can be highly beneficial for beginners. So, what is index investing? Index investing is a passive investment strategy. The investor chooses an index like NIFTY or SENSEX. Money is then invested in stocks listed on the index. The investment is made in the individual stocks in the exact same proportion as the index. The aim of this method of investment is to mimic the performance of the index. Index funds are the easiest and most commonly used method to implement index investment.

What is an Index?

An index in the simplest terms represents a select group of stocks. The numerical value of the index is calculated using the value of individual stocks. But, the weight assigned to these stocks is different. The weight may be assigned on the basis of market capitalization, trade price, etc.

The index is also referred to as a benchmark. It is mainly used to measure the performance of a market or a sector. For eg, SENSEX is used to indicate the performance of BSE (Bombay Stock Exchange). But, it is calculated only on the basis of the top 30 companies listed on BSE.

Unlike the stocks of a company, the index doesn’t actually exist. It is just a list and a number calculated based on some predefined set of rules. You cannot directly buy/sell an index.

Some of the popular indexes in India are.

  • Nifty 50
  • SENSEX (BSE 30)
  • Nifty Next 50
  • BSE Mid Cap
  • Nifty Small Cap 50

What is Index Investing?

The name “index investing” might suggest a process of investing in an index. But, as explained earlier an index doesn’t actually exist. So how to invest in an index.

Index investing does not mean investing in an index. Rather it means mimicking an index. An investor invests in exactly those stocks which are listed on the index. The percentage of investment in each stock is also kept equal to their weight in the index.

For example, if you want to invest in the Nifty 50 Equal Weight index. You will invest in all 50 companies and you will buy equal stocks for each company. But, if you want to invest in the Nifty 50 index. HDFC Bank and Reliance Industries alone will constitute 20% of your portfolio.

How does the Index Investing work?

Broadly there are two types of investors.

  • Active investors
  • Passive investors

Active investors manage their investment more actively. Their goal is to beat the market in returns. Investing in undervalued stocks, timing the market etc are some of the strategies used. This approach requires continuous monitoring and frequent changes in the portfolio. This is suitable for experienced investors, who can do in-depth analysis and can predict the market trend up to a certain degree.

On the other hand, a passive investor tries to match the market return. A passive investor uses those strategies which do not require continuous monitoring. Rather than trying to predict the market, a passive investor follows the market trend. This type of investment is suitable for beginners and intermediate investors.

Index investment is a type of passive investment method. In index investing stock selection is achieved by simply copying the index being followed. There are two ways of doing the index investment.

  • Manually select an index. Invest in the stocks listed on the index through your personal trading account. Continuously monitor the index. And, make all the changes being made to the index.
  • Chose an index mutual fund based on your chosen index. Invest in this mutual fund.

The returns in the first method will be higher in the long term. But you will have to be a little more active with your investments. Personally I prefer investing through Index Mutual Funds.

What are Index Funds?

Index funds are mutual funds that try to replicate a particular index. They have an extremely low expense ratio as they do not require an active fund manager. They compromise on the quest of generating better returns in comparison to the benchmark/index and in place take the benefit of delivering a low-cost consistent performance which is comparable to their respective index. They are a little less risky than actively managed funds, as there is very little human intervention in investment decisions and there is no pressure of outperforming the index. But, you should be aware of the inherent risk the index fund might have, for example, a NIFTY 50 index fund is an equity fund and thus have all the risk involved with equity, thus it should only be considered for investment of 5 years and more.

An important parameter to judge an index fund is the tracking error. Tracking error denotes how much the performance of an index fund has varied from the index itself. A little bit of variation is unavoidable as things like taxes, fees, and other expenses are involved with an index fund, but a variation that is abnormally high in comparison to other similar index funds should be avoided.

Advantages of Index Investing

I have zero experience in doing index investing manually. All my index investment is through Mutual Funds. Thus, the advantages that I am stating are mainly of Index Mutual Funds.

1. Easy to analyze

The most frequently asked question by beginners is, “how to select a mutual fund?”. The index funds make this quiet easy. An index fund is bound to mimic the index. Thus the only question is which index to follow. The broadest choice is between Nifty 50 and BSE, chose Nifty 50 among them as all stocks of BSE are covered by Nifty 50.

In comparison to an actively managed fund, index funds are quite easy to analyze. Even beginners can understand the reason behind the stock selection and investment strategy.

2. Low cost of management

As explained earlier index investment is a passive strategy. The same is true for index funds. Their passive nature makes them quite cost-effective. They require less amount of buy/sell of securities, thus saves on tax. They do not require continuous supervision of a fund manager, thus saving fees paid to the fund managers.

All this results in an extremely low expense ratio of index funds. The expense ratio of as low as 0.2 is common in index funds. A low expense ratio translates to returns with lower risk taken by the fund for individual investors.

3. Consistency

As the main purpose of these funds is to mimic the index, they are quite consistent. Their returns simply follow the market. On the other hand, an active fund may beat the market for a certain period. But, for one reason or another, that same fund can underperform.

One more factor ensures the consistency of index funds. They are not reliant on a fund manager for their performance. Therefore even if the fund manager leaves, the performance remains the same. Also, these funds face very few tinkering by a manager. This also increases the consistency in performance over the years.

Who Should Not go for Index Investing?

Index investing is a very good strategy for beginners. I have even seen some experienced pro investors maintaining only index funds in their portfolio. The consistency and simplicity of index investing make it quite attractive. Many individuals all over the world have enjoyed success in their investment journey. But this strategy is not for everyone.

  • Index investing comes with all the risks involved with equity investment. If someone cannot handle that risk, they should stay away.
  • Index fund responds to market fluctuation. Having patience and not panicking for every up and down is a must. If you lack this, you should stay away.
  • If you desire better returns than the index, and you are ready to take all the inherent risks involved.

The scare of Index Bubble in the USA

Recent statements by Michael Burry have started the talks about the future of index funds. The main concern he raises is that a large number of people are investing in index funds. An index fund has a small exit window. Thus, with so many people invested in index fund have further reduced the exit window. Any major exit from the index funds may cause a chain reaction. This he has stated to be the next economic bubble.

These statements were caught on by Indians too. The discussion about the sustainability of index funds and index investment is being raised in India too. First of all, I don’t fully agree with the statement of Mr. Michael Burry. But, even if you agree with him, putting the Indian market and US market on par is not at all correct.

Many estimates put index funds to be around 20% of the entire mutual fund investment in the USA. In India index funds are not even 0.5% of entire mutual fund investment (based on the asset under management). All factors apart. This alone proves that forget about a bubble, index funds are underutilized in India.

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