Index Mutual Funds: How to invest and how they work – Explained

Over longer horizons, the majority of actively managed large-cap equity funds in India underperformed the large-cap benchmark.

In the second half of 2020, there was not a single actively managed large-cap mutual fund that was able to beat the benchmark. Over the long term, not all funds outperform the large-cap benchmark. So, where should one invest? Mutual funds have emerged as the first choice for many investors. But, when it comes to picking the right equity MF scheme, the selection process often takes time and the possibility of picking the wrong MF scheme always exists.

The performance of any MF scheme, after all, depends a lot on the fund manager’s acumen in picking stocks in the portfolio. There’s a somewhat safer and simpler way of investing in MFs that will at least deliver what the stock market generates, neither less and neither more. If you are looking for a mutual fund scheme that is in line with the market returns, look no further than an Index Fund.

In an index fund, there is no role of the fund manager and the stocks mirror the benchmark that it tracks in the same proportion and weightage. So, an index MF scheme tracking Nifty 50 will have the same set of stocks like that of Nifty 50 in the same allocation and exposure.

Index funds are simply a kind of proxy to the stock market performance. If the market i.e. Sensex rises by 15 per cent annualized over 5 years, the index fund tracking the same index is expected to be generating almost similar returns.

Remember, index funds have something called tracking error that arises because the fund house charges management fees, marketing expenses and transaction costs (impact cost and brokerage) to its unitholders. Choose index funds that have low tracking error.

On the other hand, an active fund could have generated a higher or a lower return. In a way, index funds are therefore called passive funds as against the active funds being managed by a fund manager.

The index funds in India can either be ETFs listed on the stock exchange or schemes available with fund houses. Typically, both of them will carry the word ‘index’ in them. Some index funds and ETFs could be benchmarked to Nifty Next 50 and Nifty Junior, but most of the index funds are based on Nifty 50 and Sensex.

Performance – Index funds Vs Active Funds

Over the last 1-3-5 years, the average return of the index fund category has been over 60 per cent, 12.5 per cent, and 13.25 per cent respectively. Nifty 50 return over the same period has been 70 per cent, 13.5 per cent and 13.65 per cent respectively.

In contrast, active funds (large-cap) have delivered returns between 10 per cent to 17 per cent over the last 3 years and also over the 5 year period. While active funds have the potential to beat market returns, there is always a possibility of some active fund underperforming the market over a certain period of time.

Have a look at a recent report from S&P Indices Versus Active Funds (SPIVA) India Scorecard. According to the study, over the one-year period ending in December 2020, the S&P BSE 100 was up 16.84%, with 80.65% of funds underperforming the benchmark. Over the second half of 2020, 100% of the funds underperformed the S&P BSE 100. Over longer horizons, the majority of actively managed large-cap equity funds in India underperformed the large-cap benchmark, with 68.42% of large-cap funds underperforming over the 10-year period ending in December 2020.

Why index funds matter more now

Back in 2018, two key regulations in the MF industry made index funds stand out. MF houses were asked to stick to their mandate while deploying investors money into stocks. They have been true to label and invest in large-cap stocks if that’s what their mandate is and not play-around with mid-cap stocks in pursuit of higher returns. And, fund houses were asked to benchmark and compare performance against the total return index (TRI) thereby including dividends received by them from underlying stocks.

Keeping these two developments into context, the fund managers will have to make the active fund management count and deliver better returns over the long term. If over the long term, there is not a significant difference in returns and consistent out-performance, the index funds may continue to shine and remain the preferred choice for many investors.

Index fund investing

Index funds can be a good starting point for many first time investors and may even be a part of their long term portfolio. The fortunes of an active fund depend on the market calls of the fund manager across sectors, stocks and different economic cycles in the long term. In an index fund, all these are taken care of as its performance is linked to the index it tracks. But, still, active funds do have a role to play in one’s portfolio. Choosing the right one is an equally important one to deliver a higher risk-adjusted return in the long term. Stick with consistently performing active funds and keep reviewing them on a regular basis. With index funds, you can sleep over it for years together but with active funds, you may require active review on a regular interval.
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