The growing popularity of index funds in India
In the last few years, passive funds, including index funds and ETFs, have become very popular among investors across the globe. In the US, investments in passive funds have outgrown active funds in the last couple of years. In India also, we see that many investors prefer to invest in passive funds. This article will discuss the benefits of investing in index funds in India.
Why do investors prefer passive funds over index funds in India?
The major reason for investors shifting from index funds to passive funds is the inability of many active fund managers to outperform the benchmark. As per the 2021 (first half of the year) SPIVA report, in the last one year, 86.21% of large-cap funds and 57.14% of mid/small-cap funds failed to outperform the S&P BSE 100 and S&P BSE 400 MidSmallCap Index (data as of 30th June 2021).
Active funds have a higher expense ratio than index funds or ETFs. Investors pay this higher expense ratio with the expectation that the fund manager will outperform the benchmark and deliver superior returns. As more and more fund managers find it difficult to outperform the benchmark, people are shifting to index funds in India.
Benefits of investing in index funds in India
Now that we understand why many people are shifting to investing in index funds, let us understand the benefits of investing in index funds in India.
- Low expense ratio
One of the biggest benefits of investing in an index fund or ETF is the low expense ratio. An active fund may have an expense ratio in the range of 1% to 2.25%. On the other hand, an index fund has an expense ratio in the range of 0.05% to 1%.
An index fund buys all the index constituents and holds them until there are any changes in the index due to index reconstitution. As there are very few buy and sell transactions, and there is no research required to decide which stocks to buy and sell, the expenses of an index fund are very low.
So, there can be a saving of 1% to 1.5% in the expense ratio if an investor chooses to invest in an index fund instead of an active fund. The savings in the form of a lower expense ratio get added to the investor’s returns. The annual difference of 1% to 1.5% due to savings in expense ratio can result in a big difference in the final corpus accumulated 10-20 years down the line.
- Diversification
All investors diversify their investment portfolios to spread the investment risk. An index fund automatically offers diversification to investors as it has constituents from various sectors. For example, the Nifty 50 Index has companies from 10+ different sectors. On the other hand, the Nifty Midcap 150 and Nifty Smallcap 250 indices have stocks from almost all sectors of the economy. When you invest in index funds in India that have these indices as their benchmark, as an investor, you automatically get exposure to companies from all these sectors. Thus, index funds provide you with good diversification.
When you have so many companies in your portfolio, even if some of them underperform, the outperformance of other companies makes up, and you still earn good returns. Apart from diverse companies, an index represents different sectors. So, even if one sector is facing headwinds, the outperformance of other sectors makes up for it.
- Removal of fund manager bias
In an active fund, the fund manager takes all the investment decisions. The fund manager decides which company shares to buy, how much, when, and what price to buy. This decision-making creates a fund manager bias. Sometimes, this fund manager bias may work, and the fund may outperform, and an investor may get good returns on investment. But, sometimes, this fund manager bias may not work, and the fund may underperform, and an investor may not get good returns on investment.
In a passive fund, the fund manager has no decision-making authority. The fund manager has to invest in all the index constituents in proportion to their weightage in the index. Thus, in an index fund, there is no fund manager bias. Your returns mirror the performance of the index.
- No additional risk above market risk
In an active fund, the fund manager’s objective is to outperform the index. In an effort to do that, the fund manager may end up taking additional risks. Sometimes, this additional risk may work and deliver good returns. But, sometimes, this additional risk may prove costly, and you may not earn good returns.
In an index fund, there is no pressure on the fund manager to outperform the index. So, the fund manager doesn’t need to take any additional risks. The investments are made in all the index constituents as per their weightage in the index. So, in an index fund, as an investor, you are exposed only to market risk and no additional risks.
Click on the link to invest in index funds in India and build your index funds India portfolio as per your appropriate asset allocation: https://www.glideinvest.com/blog/investing-in-index-funds-in-india
