Index Funds – History, features and Active v/s Passive Investing

What are Index Funds?

An ‘Index’ comprises of stocks or securities from a particular category, industry or is a general basket of such securities. A particular Index is specifically designed with a defined calculation methodology.

For example – S & P 500 Index -US, BSE Sensex, Nifty 50 & Nifty Next 50- India

Index Funds then are funds which invests in such an ‘Index’. The Fund Manager of an Index Fund buys securities in a proportion or weight similar to that of the target Index. This implies that the Index fund is a replica of its benchmark Index.

For example – If TCS has a weight of 9 % in an Index, an index fund will allocate 9% of its portfolio to this stock.

 

Index Funds: how it all started?

John C Bogle, the legendary investor and founder of the Vanguard Group, has been credited with creating, in 1976, the first Index Mutual Fund, a very low cost investing avenue that has benefitted millions of investors.

As per Bogle, the Index Fund was created with the aim of maximizing investor returns by keeping the administrative charges and the management fees at the minimum and running the investment economically with utmost honesty and efficiency

 

Features of Index Fund:

1/ It is a diversified fund where the only role of the fund manager is to select stocks as per their representation in the Index

2/ As it is just ‘imitating’ the Index, the performance of the fund is similar to the returns from the Index

3/ As Index fund is a passive investment vehicle, the costs are very low, which makes it a lucrative investment avenue for investors

4/ Index fund’s primary objective is to match the target benchmark’s returns

5/ As far as the risk in a portfolio is concerned, the Index Fund carries the same risk as any other market-related instrument does, depending on the kind of assets it holds

 

And most importantly, as markets mature fund managers find it harder to beat the performance of Index Funds. We have seen this story play out in the US and also in the large-cap space in India. 

 

An exhaustive study by Vanguard finds

 

 

To take one example, 72% of U.S. large-cap value equity funds under performed their benchmarks over the ten years ended December 31, 2014. The case for indexing has been strong over shorter horizons, too, although shorter sample periods have tended to produce slightly more erratic results. The case for indexing over longer horizons such as 15 years has also tended to be strong.

 

 

Similar returns have been shown in academia for all investment horizons and in almost all markets including India.

 

Tracking Error

Although by design, the returns generated by an Index Fund should match the benchmark returns, however, there is some difference between these two returns. This is due to the Tracking Error.

Tracking Error is the difference between Fund returns and the target benchmark returns. It is depicted as a percentage.

1/ Tracking error could be due to various factors – fund expenses, changes in level of cash holding, change/difference in underlying securities, corporate action and  buying-selling restrictions on a specific stock

2/ A lower tracking error indicates that the fund is very closely following its benchmark and vice versa

3/ An index fund with the lowest tracking error would be the best

 

Tax treatment

The tax treatment for Index funds is similar to diversified funds. On redemption, the capital gains (or losses) so realized are taxed as per the rate and period of holding.

Long Term Capital Gains (one year and above) over and above the exemption limit of INR 1 lakh would be taxed at 10%.

Short Term Capital Gains (holding period of less than one year) are taxed at 15%

 

Should you Invest – Index Funds v/s Diversified Equity Funds

1/ The cost of choosing a wrong fund or a poor advisor can be huge. Index Fund safeguards from this – it allows an investor to benefit from the equity markets without worrying too much about benchmark beating returns, that too at a minimal cost. The difference in cost against diversified funds can sometimes be as high as 125-150 basis points.

2/ The difference between expense ratio for an Index Fund and an actively managed diversified fund over a long period of time can be substantial. Even amongst Index Funds, the one with the lowest expense ratio will be the best to choose from.

3/ Index Fund investing does away with the biases of a Fund Manager – a Fund Manager might sometimes pick some rank underperformers and stick around expecting a turnaround.

4/ A Fund’s philosophy and style might change after a particular Fund Manager’s exit. There is no such issue with an Index Fund.

John C. Bogle, in his book ‘Common Sense on Mutual Funds’, had this to say about Index Funds:

 

 

The index fund is a most unlikely hero for the typical investor. It is no more (nor less) than a broadly diversified portfolio, typically run at rock-bottom costs, without the putative benefit of a brilliant, resourceful, and highly skilled portfolio manager. The index fund simply buys and holds the securities in a particular index, in proportion to their weight in the index. The concept is simplicity writ large.

 

 

Are Index Funds available in the Indian Markets?

Index Funds have seen a surge in the Indian markets as storied fund managers have found it hard to beat benchmark index returns. A wide array of index funds are available for the Indian investors now. We recommend two such funds as a core holding as part of our equity portfolio.

1/ UTI Nifty Next 50 Index Growth Direct Plan

2/ DSP Equal Nifty 50 Growth Direct Plan

You can find all Indes Funds available on Kuvere here.

 

Conclusion:

Warren Buffett has been a strong proponent of Index investing and said in 2017 to CNBC-

 

 

The trick is to essentially buy all the big companies through the S & P 500 and to do it consistently.

 

 

Index Funds have been very popular in the US where, with maturing markets, actively managed Funds on average do not beat Index Funds. In India, Index investing is still in its nascent stages but is expected to pick in a few years when the markets mature and the Indexes are better designed.

Keeping in mind the goals, investment horizon and risk, an investor would do well by choosing a mix of diversified funds with some Index Funds. For beginners, though, Index Funds could be an investment of choice, to start with.

Choose well and stay invested!

 

Visit www.kuvera.in to invest in “Direct Plans” of Mutual Funds and save BIG on commissions!!!


1 Responses

  • Vandhiadevan Varadharajan

    October 4, 2019 AT 03:24

    Do you have any back-tested data to show how Index funds give better returns than a diversified active Mf over the period(Maybe 5/10/15 years).
    In case direct vs regular funds, there is lot of gap in the return generated by direct funds. Same way i would like to know, cost wise, how Index funds performing better than Active funds.