Index funds are an easy introduction to passive investing
By: Tavaga Research
As Indian markets mature, investors are increasingly discovering investment instruments that address their sharply-defined needs (and risk appetite). Refinements of existing products are ensuring retail investors don’t have to depend on just vanilla offerings. Index funds are one such group of investment products that exist within mutual funds but behave like a passive investing instrument.
Index funds are pooled funds that invest in an index, which is a yardstick to compare performances of securities traded in the market.
The Nifty 50 and the Sensex are India’s best-known indices, the benchmarks for the NSE and the BSE, respectively. There are, of course, other indices tracking commodities securities, gold, sub-indices tracking banking, infrastructure stocks, etc. on the same or other exchanges.
Index funds, then, aim to follow the performance or the returns on indices closely. There is an investor need they address with such an objective.
Index funds, much like other forms of passive investing, bank on the merits being in line with benchmark performance.
Benchmark indices are made up of a basket of stocks that reflect the performance of the broader market.
Indices reflect the influences on the larger market, i.e. the systematic risks, and do not run the risk of idiosyncratic risks or unsystematic risks. Thus, the regular retail investor is sheltered from one of the two risks associated with markets, altogether.
Index funds are mutual fund products, bringing with them some of their characteristics too.
Investors pool their money and the common pool is invested by a fund manager in the market. The difference here is rather than pursue alpha, the fund manager invests in an index, predetermined, to mimic it.
Index funds allocate its pooled funds in all the constituents of the given index in the same weightage as making up the index.
A Nifty 50 index fund, for example, will invest in all the companies on the Nifty 50 by giving them exactly the same weights (ratio of each company’s stock in the collection) as on NSE’s Nifty 50 index.
If say, HDFC Bank has a weightage of 3 percent on the Nifty 50, the index funds will also give a 3 percent weight to HDFC Bank in their portfolios.
Lower expense ratio — Since an index fund invests passively, we don’t have to sign up for a significant churning of the portfolio (adjustments such as pulling out of a security and reinvesting elsewhere, etc. to pursue alpha).
Even choosing what to invest in becomes a predefined brief as the objective is to replicate the underlying index’s performance. AMC’s research team does not have an elaborate role to play in helping the fund manager pick up stocks that generate alpha.
These two factors lead to a lower expense ratio as the fund manager’s mandate is smaller than that of an active MF’s.
Here is a comparison between expense ratios of a traditional MF and an index fund:-
Large-cap equity funds, then, can charge up to four times the expense ratio (fee) of index funds.
Diversified investment — Index funds allow us to diversify our investments by placing the money in different companies from various industries. as present in an index.
Diversification —is a crucial step in mitigating risk when investing, without affecting the returns of the portfolio. Investing in a variety of companies with different businesses is a way of doing it, which an index fund lets us.
We present the verticals of the companies present on the Nifty 50 index in the pie chart. Index funds investing in the index would then have exposure to at least 13 different industries, increasing the chances of offsetting a dampener in one with growth from another.
Index funds as a passive financial instrument are simple to understand and maybe a good fit for those who don’t have the wherewithal to understand financial reports or spend time on fundamental analysis. These two are crucial to picking individual equity stocks and build a diversified portfolio. Index funds let us enjoy the diversification without the legwork.
If we would rather park our money in an instrument without the constant need for monitoring, index funds could be one of the products to consider.
An index fund also does away with the need to time the market as we are not required to pick stocks based on fresh information but let the fund do the work. As a passive investment, the index funds don’t need to change the group of securities too often, which is an added bonus compared to active funds for the retail investor.
While studying index funds, we should remember it is but one of the products which populate the passive investing universe.
Passive investing is at odds with active investing in the form of MFs that Indian retail investors have known for years.
Passive investing is now being spoken of increasingly among experts in the industry.
According to the scorecard published by SPIVA (Standard & Poor’s Indices Versus Active), which rates actively-managed funds with S&P indices, in the calendar year 2019, the S&P BSE 100 surged 10.92 percent, with 40 percent of active funds underperforming the benchmark. In fact, across all the periods (except 1 year period) studied, the majority of actively-managed large-cap equity funds in India underperformed the S&P BSE 100.
In the report, over a three-year period, the benchmark index outperformed 84.38 percent of large-cap equity funds. Only 15.62 percent of large-cap active investment funds could beat the benchmark index.
In investment funds, large-cap equity funds are the stalwarts offering growth from credible stocks. But with these funds, investors pay five to 10 times the fees they pay to invest in passive funds.
The premium is paid for a clear mandate to their fund’s managers — the mandate to generate alpha. But as Spiva shows, fund managers have consistently missed the mark with their active funds.
Large-cap companies often have a wealth of information available with investors, making it more difficult to achieve alpha.
With more swathes of the market maturing this way, passive investing becomes more tenable as it entails lower fees, lower risk, and comparatively good returns.
Passive investing which often tags the instrument to an index has little authority over the securities of the invested group as it is the same as the benchmark index. If an investor has a problem with any of the constituents (reasons could be a company damaging the environment or being cruel to animals through its operations, or some other principles at odds with those of the investor), there is no way to boycott it.
With passive investing, including products like index funds, we forego the chance of big-ticket gains that come from disproportionate gains in the market, unlocked from selectively available information or research.
But even then, we may ask ourselves what should prevail — greed for some unknown gains or consistent returns. Passive investing banking on benchmark indices is promising because the primary indices in India are better off than those of other large economies.
The list below shows how the Nifty has given high enough returns compared to many other major economies in the world:-
Passive investing, then, has a lot going for it. Index funds are a kind of passive investing, despite being mutual funds.
But there are some disadvantages associated with index funds.
Before investing in index funds, we have to understand that we are not investing in an index, rather we are investing in a tool that replicates the performance of an index.
As a tool, the index funds have their own drawbacks. One of the peculiarities being the tracking error.
Tracking error measures the difference between the performance of an index fund and the benchmark it tracks. Tracking error may arise because of the transaction costs, change in the benchmark constituents, etc.
Tracking error can be calculated as follows:-
Where TE is tracking error, R^2 is R squared, which shows the explained variance and σ is the standard deviation of fund returns.
The ‘R squared’ metric measures how closely the fund is replicating the benchmark. It can range between 0.01 (1 percent) and 1 (100 percent).
The higher the R-squared number, the truer in performance the fund is, with 1 signifying the index fund is perfectly positively-correlated.
When picking an index fund, we should keep an eye on its tracking error, and choose the one with the lowest tracking error or the highest R-squared.
Of course, as a market-linked product, an index fund runs the systematic risk. The benchmark index it follows might underperform due to wider market drags and affect the fund’s returns too. But that will get offset with time as the markets go through ups and downs, giving good returns, as well, mitigating intermittent poor performance.
Index funds have a close competitor in exchange-traded funds or ETFs. Traded on an exchange, the underlying securities of ETFs also mirror the composition of the index of that particular exchange (stock, debt, or commodities).
However, ETFs are not mutual funds and hence, are different from index funds in a number of ways. There are some pros ETFs possess that index funds cannot offer.
Index funds units are bought by an investor from the AMC, as they are open-ended funds and are available on the primary market. ETFs, on the other hand, are first floated in a primary market and then are traded, like common stocks, on the secondary market.
The value of an index fund unit is the Net Asset Value or NAV declared at the end of the trading day by the fund house. While for ETFs, the purchase price of a unit is its spot price on the exchange, which is the secondary market, even though ETFs have a Nav as well.
Index funds when compared to ETFs have larger tracking errors. Managed and issued by fund houses, index funds need to hold cash reserves to honor redemption requests, which adds to the tracking error margin (as less than 100 percent of a fund is invested). ETFs, freely traded on the exchange, don’t have a retail redemption process beyond the trading on the market.
Of course, ETFs have a separate creation and redemption process for liquidity but that does not involve retail investors.
However, index funds have a lower expense ratio than ETFs. An ETF unit trades like a stock, so it involves trading costs such as brokerage, STT, and the bid-ask spread, inflating the effective expense ratio of ETFs. Index funds, on the other hand, have lower fees given that they don’t need to be traded like ETFs nor do they entail active management fees like mutual funds.
Being an open-ended fund, an index fund allows incremental deposits or investments to be made in the form of a SIP. A SIP relieves the investor with having to time the market with lump sums to invest by regularising investment with timed installments. It also averages out the purchasing price.
With ETFs, a straightforward SIP is not allowed. But there are ways to replicate an investment at regular intervals with ETFs.
Following is the list of the 10 top-performing index funds in India in the last three years:-
It is to be noted that these returns are the historic returns and may change. Investors should choose products that are likely to give returns that suit their goals.
Index funds are uniquely placed to reap the benefits of passive investing. If picked carefully, they can diversify our portfolio in a valuable way.
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