As markets touch historic highs, index funds continue to offer exciting returns! Should you invest?

• For an index fund, the expense ratio is almost next to nothing, whereas for actively managed funds it could be as high as 2%
  
• If you do not have the time or the expertise to study the fund manager or his style, you should consider passively managed funds
  
• Index funds may also benefit savvy investors who want to manage only part of their portfolio actively
  

Interestingly, the first theoretical model for index funds was suggested by a couple of students at the University of Chicago in 1960, but their idea found little support at that time. But as we know, index funds were popularised in the 1970s by John Bogle, the chief executive of the Vanguard Group, who is also known as the father of index funds.

Index funds are funds that aim to replicate the performance of a specific market index, such as the NIFTY 50, Nifty Midcap 150 etc. These funds passively track the composition and performance of the underlying index rather than actively selecting individual stocks. They track respective indices, investing in the same securities in proportions mirroring the index.

“These funds offer passive management, low cost, and instant diversification, making them popular among investors seeking exposure to specific market index while minimising costs and risks,” says Pankaj Shrestha, Head, Investment Services, Prabhudas Lilladher.

Types of index funds


On the other hand, we have actively managed funds where the fund manager decides what stocks to buy, hold, or sell. Hence, these funds have a higher expense ratio. Actively managed funds have the potential to beat the benchmark, though this may not always be the case.

Are index funds for you?

In an index fund, you exactly know where the fund manager is investing. In the case of an actively managed fund, you need to know about the fund, and whether the fund manager will be properly following the mandate or not. Therefore, in addition to the fund’s potential and reputation, you need to study the fund manager, their investment philosophy, and track record.

This is not the case with an index fund where the style of the fund manager is not a worry. The most significant advantage is the expense ratio. For an index fund, the expense ratio is almost next to nothing, whereas for actively managed funds it could be as high as 2%.

“A lot of people say that they invest in gold as a hedge against the equity markets. We can also say that passively managed funds like index funds are some kind of a hedge to actively managed funds style. Within equity, some allocation should always go to a passively managed fund. In the last few months we have seen that many actively managed funds are underperforming the benchmark,” says Hitendra Parekh, Fund Manager, Passive Funds, Quantum AMC.

Those who do not have the time or the expertise to study the fund manager or his style should go for a passively managed fund. For this reason, for the beginner investor, passively managed funds are a good way of investing.

As we have seen, buying an index fund can also give you exposure to different sectors like financial services, auto, pharma and so on.

“Auto for instance is at the cusp of a technology change. We are seeing a proliferation of electric vehicles (EVs) as a technology, which can be a new driver altogether. But if you do not know who will win, the next best thing you can do is to buy the entire index,” says Varadarajan.

For this reason, Varadarajan believes that to say that index funds are for beginner investors is an oversimplification. “Index funds can help even the savvy investor. He may want to manage some part of his portfolio very actively wherein he knows the bets he is taking, the company, the management etc. However, if there are opportunities that are coming at a sector level and it is a sunrise sector, and you are betting on a large part of the sector through an index fund, then you will benefit over a period of time without having to worry who will be the winner etc” he says.

How much allocation one should have towards index funds would vary from investor to investor. “If there is 70% allocation towards equity, the investor should deploy some 15-20% in passively managed funds,” says Parekh.

What to look for when selecting an index fund

Before choosing an index fund, one should consider the following factors.

Select the proper index: Since now many index funds are available, the first thing is to choose where he wants to invest, whether he wants to track a market capitalisation or sector and so on.

Expense ratio: Look for funds with low expense ratios to minimise costs and maximise returns.

Tracking Error: “Assess the fund's ability to closely track its benchmark index over time to ensure it effectively mirrors market performance,” says Shresta.

Historical Performance: While past performance doesn't guarantee future results, reviewing the fund's historical performance relative to its benchmark can provide insights into its tracking ability and consistency.

Even the Oracle of Ohama, Warren Buffet bats for index funds. When investing, sometimes you need to go passive.