Index funds offer ease of investing and cheaper alternatives to actively managed funds, but the ease comes with some cons.
In recent years, index funds, a type of passively managed mutual fund, have soared among investors in popularity. These funds track larger market indices like the Nifty 50 and S&P BSE Sensex, or small indices like the Nifty midcap 50, and can be cheaper for investors because of less management expenses as a fund manager's service is minimal when tracking an index. However, despite their apparent advantages, there are several downsides investors should consider before diving in.
Solely if one compares large-cap funds, it can be observed that active funds outperformed passive funds.
Over a one-year period, out of 21 funds evaluated, over 70 per cent of large-cap funds surpassed their benchmark which is the NIFTY 100 Total Return Index. Similarly, over five years, over 60 per cent of funds outperformed their benchmarks. Notably, the overperformance rarely was of a large margin but when underperforming there was only a marginal difference. In a year's tenure also majority of funds outperformed the NIFTY 100 Total Return Index.
Ignoring Stock Fundamentals
Unlike an actively managed fund, no fund manager analyses the fundamentals of the stock that an index fund invests in.
Index funds only mirror the market capitalisation of companies listed in the index. For instance, if 'Stock X' has a 10 per cent weightage in the Nifty small cap index an index fund tracking the index will also have to hold a weightage of 10 per cent of its portfolio in 'Stock X'.
Suppose due to the recent surge of enthusiasm over small caps, lots of investors pour into this stock, and it gets overvalued. The market capitalisation of that will increase, and the index fund will also increase its investment in that stock, leading to exposure to overvalued stock. Similarly, if investors collectively undervalue a particular stock, index funds will also choose underexposure. This strategy goes against age old wisdom of buying low and selling high based on stock fundamentals.
Sebi has earlier this month proposed that exchange-traded funds (ETFs) and index funds, can invest in stocks without any caps. Currently, they are restricted in their investments in sponsor group companies, with a cap of 25 per cent of net assets, but to freely mirror the index, this cap is proposed to be lifted. This can further exacerbate the risk of overconcentration in a particular stock. Actively managed schemes can not invest more than 10 per cent of their funds in a single stock. This restriction does not apply to index funds.
So when there is a bull run in an overconcentrated stock an Index fund will benefit but during a market downturn if any of these heavy-weight stocks come under pressure, investors are not in for a safe ride.
Index funds tend to overweigh established market leaders, which may have little growth potential compared to smaller, but new entrants regardless of market capitalisation. The past performance of these giant companies does not guarantee future returns.
Also, a trend is evident, that large companies even when directly involved in a scam or regulatory lapse will immediately be sold by active fund managers. But in the case of passively managed funds, these companies will be part of its portfolio because it is part of the index. As long as a company maintains its market capitalisation in line with the index, it will be part of the index, which is not a perfect criterion for investment.