What is Index Fund and Why We Should Invest in Index Mutual Fund

The Index fund is one of the largest mutual funds in the world, although most investors in India are not aware of such investments, and even if they know, they opt for actively managed funds only. However, in the last few years Such behavior has changed. Index Fund is still a small category in India. Today we will understand index funds with symbols, learn about the advantages and disadvantages of such funds, and As an investor, you will understand how to decide whether you should choose these funds or not.

When we look at an index fund some questions in our mind, that what is the index in that index fund and how and where to invest these funds. How do you use this index in doing this? So, usually as you know, according to me, there are two types of investment. One is active investing and the other is passive investing.

In Active Investing, you actually give your money to a professional fund manager who's Skill, knowledge and experience determine which stocks are better to buy and which are the worthless stocks that should be sold. This is active management, which is obviously very special and is where most money is invested.

The second part of, at least in mutual funds, is called Passive Investing. In passive investing, your investment strategy is usually not to give your money to a particular fund manager, in fact there is no fund manager for you. The purpose behind passive investing is to repeat the returns of the index. 

What do I Mean by Index? 

I am sure many of you must have heard of SENSEX or NIFTY. You know that NIFTY , There are top 50 stocks in the country and SENSEX is the top 30 stocks in the country.

What is Index Fund
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What Does Nifty Do? 

This gives you an average view of what is going on in the market. So, the objective of an index fund is to give you complete information about Nifty returns. If Nifty goes up, let's say 10%, your portfolio in Nifty 50 index fund is also 10% Will almost go up. So, this is how it works.

As you know, as AMC, as a mutual fund, what we do is, whenever we get cash from our investor, we buy The top 50 stocks in equal proportion to the index itself. For example, Reliance has a 10% share in the index. The aim would be to invest 10% in Reliance. Our objective about index funds is just to replicate index returns.

One of the major reasons for index funds being so popular is the low cost. Apart from this, there is a misconception that there are only 2-3 indices in India, but there are actually several hundred indexes. Rather there are thousands of indices all over the world. There are lots of indices everywhere, large cap, mid cap, small cap, multi cap. So, I think, there are many options in this space is growing in India. It is the index fund.

So, when we gave an example of an index, then we told how index funds work and how to replicate them, but if we look at examples that we said like Sensex and Nifty, they are not really diverse. Has a weight of 29% of financial services, nifty 50 is also a weight of financial services. Doesn't that increase the risk of the investor? So, you know, the index is actually a very beautiful thing because the index is not stable over any time period. Let me give an example, in 2004, the index was industrial, material was, capital school. Today index is financial services, tomorrow maybe it can be media, it can be telecom. The thinking behind buying index funds is the top performing company all the time. Index re-balances itself every 3-6 months.

So, I think, if you look at choosing stocks, today more Most stocks, I would say 70-80%, have not been able to go back up until 2007. But since then, the index has gone up two and a half times. So, the idea behind the index strategy is that the market itself Let yourself be the fund manager. Let the market decide what / who will do better, who will do bad. Yes, today I agree, today the index weight-age is highest on financial services, but, 10-15 years to come. This may or may not change. But, India is one of the few countries where there is a lot of diversity in the sector. In other countries, such as if you look at China, look at Russia or other countries, they have a lot There are all the sectors that play a much larger role in GDP than India. It is the idea that the index should be developed. Let the market decide which is a big company, which is a small company and quarterly or half yearly. Because of re-balancing, you can make sure that you always have a better company.

Is This a Lack of Active Management? 

You know, to exit a stock, you have to wait for the index to change. Now, sometimes it may be too late for some growth. For example, Yes Bank What happened in the case, you know. When it fell down and its index changed, you know it was removed after that. The same thing happened in the case of PNB. What are your thoughts on this? Is this the end? I will not affect the returns that the investor is getting from investing in this approach. Rather from what we have seen, when it comes to actively managing your money, I think, when things go bad, you obviously have the option to sell those stocks at the very earliest opportunity, unlike an index. If you think about the other side of it, most of the activities of selling shares have happened after YES Bank goes down or DHFL and the quality of the index is that as the share price goes down, its importance decreases. 

Let me give you the example of Yes Bank, you know Yes Bank is a big company, but when it went down, you know that the index also fell due to its impact. But when it sold out of the portfolio of index funds, I think we had less than 1-2% exposure. For example, most people bought Reliance shares last year or this year because now they see that this is a good strategy but if you have already participated, you would have always bought Reliance and you had played this game long ago. So you can actually work both ways. You can get a future leader on the very first occasion. You know When this is going on because you have to buy it much later, and yes as stocks fall, it means less and less importance over time, and as stocks move up, it has the opposite effect, You know it becomes more and more important in your portfolio than when it was a small company.

So, I think the index that does this re-balancing itself determines that a bad company gets less value then a good company. To get more and more importance over time, so I think that, if you look at, like not India, but look at the US or Europe, index funds that really do better than most active funds Because they adopt this good strategy, as well as save the investor fees due to low cost. So, by giving example of symbol Reliance.. Leads to another question again. Whatever is happening here, if you look at it, a lot of money is put on these select stocks. The big company is getting bigger and people now want to buy these quality company shares. Now, due to their demand, the prices of these stocks start rising and they go above their long-term average. Now as an index fund you do not have the option to choose stocks that are clearly at this time But quite expensive or even the market. When you are in an index fund, you cannot even think about cash. Due to this compulsion momentum is not able to stay out of stock or something that is going on or then whatever the reason is, knowing how harmful it is for you to know the long-term returns or whether it can affect the returns of the investor. So, I think, I mean ideally you are buying Index and I don't know this is momentum. So, the index has no strategy. 

Index is basically a market cap weighted strategy. This index does not have any momentum. Index will not choose, So people are choosing growth and price. In the index it doesn't matter whether you choose growth and price. Today index growth is oriented. Many growth stocks really give prominence. But tomorrow if suddenly, when it comes to price So the index suddenly starts repeating higher prices. I think the index is good. I think this is the reason why active funds perform better and worse because they follow certain strategies. So, we have all learned that an active It is very difficult to get the fund out of the year-to-year index. It will perform poorly at times and will perform better than expected. The index is somewhat stable, the index is the site that is working. So, I think that as a strategy is even easier for the investors today. They do not have to make a decision, or choose from five thousand or ten thousand active funds, and even after buying them, which is hardly a process with Indians. This is their behavior, sell the fund that is performing less and buy the fund that performs more. Their culture of buying the fund is not the right decision. I think the average holding period of a mutual fund in India is going to be three years which is really a matter of concern. 

I think, the index makes it easier because You will never have a risk or you will never feel that you have taken the wrong fund. In fact, we have seen that the customers stick to their decision. They are never a disappointment because as a strategy they never perform less. So, I think index funds are much easier according to management psychology. 

Yes if one wants to take a decision between Momentum vs Growth So obviously the index is not the right strategy, but just pure market exposure and letting the market decide whether it will do well is also a good strategy. Let it run as it is or if you want to buy them, you can pay in the satellite fund and buy a high performing fund. I believe that combination of these two would be great for investors because if you are dependent on just 100 percent active, and there can be a situation that all your funds are performing below the index level which is not a good sign. Do not recommend satellite portfolios but we insist simplicity But more than that, it is difficult to go wrong with index funds.

I believe that investors should choose index funds on the basis of what kind of problem it is solving. If you are looking for mid-cap. And if you do not want to choose from 150-200 mid-cap funds, then you can buy the index. Its returns are also very much like mid-cap funds. I think the key to real success is simplicity. And yes, I agree with you that this information is balanced. The level of large-cap has gone down so much in our large-cap space The ability to beat the benchmark, especially when you are charging higher fees, is much more difficult than it was three or four years ago.

So I believe that investors looking at a large-cap strategy have at least one Or there should be two index funds so that they can ensure that their returns are stable, but in an ideal situation I think the whole purpose of index funds is to make things easier and if you are looking for a multi-cap fund and nowadays many new investors like you come. It is a bit difficult for them to go and choose the right fund and index funds make it easy. It is effective, low cost and you can hold it for a very long time. I think this is the essence of index funds. 

Each time we also told that people should see their need and then choose index fund. So now index fund is also an option, whereas there is no difference in the way index funds work. In such a scenario, on what basis should an investor choose among the options given in his index fund category? 

I think investors should keep two things in mind when choosing a right index fund. The first is expansionary. Overall, the purpose of index funds is to monitor the index as carefully as possible. An investor should be aware that he will not actually get benchmark returns. There will always be a difference between index and your returns. Which will be maintained every year. So I believe that try to find a fund that is at least in cost because the lower the cost of the fund and the returns will be good. Your benefit will be on the index itself. So I would suggest that investors should pay attention to expansions. The other important thing is to pay attention to tracking errors. Generally, funds that have the least tracking errors are more easily represented by the index. Funds that have maximum tracking error. So according to me should keep both these things in mind when choosing a fund. 

If we talk about options, luckily, we do not have much options in India right now, whereas in the US market there are hundred or thousand ETFs and index funds. I think there are not so many options in India and all funds are almost the same. So if you want to adopt a large-cap strategy, then Nifty and Next Fifty may be right for you. These are both good and I think If you are looking for a strategy that makes you want to have a high growth portfolio, then the Nifty is right for it. 

Next, in the mid and low-cap space, we have Motilal Oswal who is the only index provider of index funds in the multi-cap space. Funds can be used there. According to me internationally, every investor should go ahead with at least 10-15 percent exposure in International Index Fund irrespective of age, experience, profile because it is really your portfolio. Reduces volatility and gives you true diversity without leaving returns.

So more diversification means debt, gold etc. These returns are slightly lower, while it is an asset class where you can get very good variety without giving returns and I think it is an international strategy, take a gold ETF, small Invest the part there, and if you are a little risk-taking person, then you can think of large and mid-cap. If you want a lot easier then Nifty 50 or Nifty 100 are good options. 

What a Tracking Error Is? How Does it Ultimately Affect the Returns of an Index Fund?

Actually tracking error is straightforward. That means how well your portfolio and fund are tracking the index. If the index is up, suppose 10 percent and your fund is only 9 percent, then it is a tracking error. But in reality most people do not understand that. How the tracking error is calculated, tracking error is usually the standard deviation of daily returns in the index and It seems that the lower the tracking error, the closer the index will be able to track the fund. That's why I think less and less about the tracking error. There are a lot of misconceptions related to tracking error that these index returns and fund's the difference between returns is not true. There is no popular or separate word for this, but ideally one should look for a low tracking fund. I think many funds that have completed three years should be disclosed in the track sheet so that you can track the tracking error. You can use the track sheet for this. There are a lot of new funds available today and you should give them some time to develop good tracking. So ideally you should not look at tracking errors from the perspective of three or six months. Should be looked at by 2 or 3 or 4 years. This is where a fund really shows how good it is in terms of tracking the index. 

My last words will be, I think you know that this is a very difficult time and I would say that investors should try to maintain liquidity clearly, so that it make sure your expenses are covered. I will also tell investors not to stop investing. Bad investors in the market When it barks, it becomes a lion and pulls its hands back when the market condition is bad, good investors remain the same in bad and good condition of the market and very good investors invest when the condition of the market is bad and the market boom. I don't think it is important to be good. Keep a fixed allocation strategy, decide that you stick to it because ideally what we have seen in terms of data is that of fund returns and investors returns. There is a big difference. 

Many of us spend most of our time knowing what are good funds and what is the right time to buy them. But one thing, I have learned in last few years You cannot decide the time of the marketer according to yourself. So it is very difficult to find out which is the right fund. So keep an allocation towards all the assets and then balance it again. Second thing, behavior is very important. Investment is 10 percent process and 90 percent is psychology, so I think it is very important not to stop the SIP, it is very important to invest and not to react to the market.

Again At the start you get high returns because there are constant changes in the market and I think not in India, but America, they have seen two world wars, money strapped, inflation in spite of seeing the markets so far. That's all from my side.

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