Mutual funds are a transparent and low-cost investment option for young investors. However, picking a suitable mutual fund scheme from hundreds of different options is easier said than done. A low-performing scheme can impact the return of the entire portfolio. In this context, the past few years have seen quite a few investors moving to index funds. Let us look at what index funds are, their benefits, and whether you should choose index funds over actively managed funds.

What is an Index Fund?

An index fund is a fund that mirrors its investment portfolio to the index, for example, Nifty 50. There is no active fund management in these funds, and thus these funds do not face the risk of human bias in stock selection and taking calls on the market. The endeavour of these funds is just to earn a return similar to that of the index. The fund aims to hold the stocks in the same proportion as the index.

Index funds are an evolving market in India. You can find index funds aligned to the following indexes:

NSE Nifty 50 Index, BSE Sensex, NSE Nifty 100, Nifty Midcap 150 Index, NSE Nifty Next 50 Index, NSE Nifty Smallcap 250 Index Fund, Nifty 500 Index, Nifty Bank Index

Reasons why Investors are Warming up to Index Funds

There are basically three reasons why investors are moving to index funds in recent times as follows:

1. The most crucial reason driving cost-conscious investors to these funds is its low-cost nature. While most active funds have an expense ratio in the range of 1.5–3 per cent, these funds have a meagre expense ratio. For example, the expense ratio of the direct plan of HDFC Top 100 Fund is 1.29 per cent. Compared to that, the expense ratio of the HDFC Index Fund–Nifty 50 Plan is a mere 0.10 per cent (Source: HDFC MF Fund Factsheet March 31, 2021). Over the long term, this savings in cost can translate into significant returns.

2. It is not that these index funds have gone cheap in the past few months. Investors were willing to pay a higher cost until active funds generated a higher return than the index. However, this trend has started changing over the past couple of years. Mostly, you find active funds deliver returns in almost the same range as that of the index. Some marquee names even delivered lower returns than the index. Their stock calls outside of the index did not perform as expected.

3. There is always this pressure on the investor to ‘choose the right fund’. Given hundreds of mutual fund schemes and a lack of genuine and honest advice, investors end up choosing funds that performed well last year but turned into a poor performer this year. As investors mature in their journey, some find index funds as a less-stress route to active investing. There’s also the belief that everything evens out over the long term.

Keep in Mind the Following Important Points before You Decide to Invest in These Funds:

Index funds are not risk-free. They are subject to the same fluctuations of the market as an active fund does. In fact, during periods of high valuations and market volatility, the index funds do not have the leeway to move the investments to cash or buy at lower valuations which goes against them.

Performance-wise, the index funds have a better chance to match the performance of large-cap funds. The role of fund manager comes into play as one goes down to mid-cap and small-cap funds.

There is always a slight difference between the returns of these funds and those of the index. This is because of ‘tracking error’, which means the extent to which the fund’s composition deviates from the underlying index. You can find tracking errors from the factsheet of the fund available on the mutual fund’s website.

Saying that index funds are cheap is a generalisation. It depends on the index chosen and the Assets Under Management (AUM) of the fund. Some index funds have an expense ratio as high as 1 per cent, defeating the cost-saving purpose of the fund, so check the expense ratio before investing.

The taxation of these funds is the same as any equity fund.

Our View: Should you Switch to Index Funds?

While developed economies like the US have embraced indexing as an investment strategy, it will take some more time for Indian investors to adopt it. Active funds do hold their ground as of now, especially in the mid-cap and small-cap space although index funds may help you save on costs and prove a better alternative to actively managed large-cap funds.

You can take a middle path by having a mix of actively managed and index funds. Instead of selling actively managed funds and buying index funds (which can cause tax implications), you can channel your incremental investments into index funds.

As time progresses, more investments in these funds help reduce expense ratios further. Also, the performance gap between active and index funds may narrow across market capitalisations. These developments can then help you make a call to fully move into these funds.

The author is Founder, FinBingo.com

DISCLAIMER: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.