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Who Should Invest In Index Funds and How It Works?

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An index fund can be defined as a mutual fund that imitates the portfolio of an index. Several investors are aware of the benefits of diversifying their portfolio across assets. Hence, Index funds often catch their eyes in their search of funds that invest in a broader market index. All the stocks in these indices would find some representation in their investment portfolio.

Index funds are not actively managed and hence these funds incur low expenses. Their main aim is to maintain uniformity in the market that helps an investor in managing and balancing the risks in their investment portfolio.

How do Index Funds work?

An index is a group of securities that defines a market segment. These securities can be bond market instruments or equity-oriented instruments such as stocks. Some of the popular index funds in India are BSE Sensex and NSE Nifty. Since index funds India fall into passive fund management, the fund manager can decide which stocks need to be brought and sold, consistent with the composition of the underlying benchmark. While an actively-managed fund finds it difficult to beat its benchmark, an index fund’s role is to match its performance to that of its index. Also, the Index fund’s role is to deliver returns more or less equal to the benchmark.

Who should invest in Index Funds?

Index funds are best suitable for investors who are risk-averse and expect predictable returns. For instance, if you wish to participate in equities but do not want to take risks associated with actively managed equity funds then you can choose between Sensex and Nifty index fund. These funds will give returns matching the upside that the particular index sees.

Best Index Funds in India

Some of the best index funds in India in 2020 are listed below:

  • ICICI Prudential NV20 ETF: This scheme provides an investor with the opportunity to select stocks at relatively lower valuations. Being an open-ended equity, this fund is a moderately high-risk investment and appropriate for investors who have a long-term investment horizon of more than 5 years. Low cost and low fee structures are some of the other highlights of this scheme.
  • SBI ETF Nifty Next 50: This scheme is a moderately high-risk investment and is best suited for investors who are seeking long-term wealth creation by investing in Nifty Next 50 companies. The fund helps investors in becoming a part of such companies that are on the verge of making it big. The scheme is also a cost-effective and a convenient method for investing in upcoming top companies.
  • UTI Sensex ETF: The scheme is suitable for investors who want to build their portfolio around passive investing. Being a large-cap index fund, UTI Sensex ETF is a moderately high-risk bet and appropriate for investors who have a long-term investment horizon of more than 5 years.
  • HDFC Sensex ETF: This scheme is an easy way to replicate returns corresponding to the Sensex. It enables investors to benefit from the upward movement of Sensex over a long-term period. Investments in HDFC Sensex ETF will be moderately high-risk. Only investors with high-risk profile and investment periods of more than three years should consider this fund.

Value of Index Funds in 2020

Index funds comprise of passive investments and their popularity has grown worldwide. Indian investors are also seeing the benefits of investing through low-cost index funds. Passive investing is becoming famous in India as Indian markets are turning competitive thanks to the presence of an outsized number of active asset managers like mutual funds, best Sip plans in india, insurance, companies, foreign investors, etc.

Currently, in the Indian market, active funds are outperforming the index funds since people are not very keen towards investing in index funds, as of now. But this might not be the case in the future. Fund managers eventually have to show skills in the way they pick stocks and give extra returns over the index. Reasons include SEBI’s re-categorization exercise, the total return index, and lastly, as the market becomes more efficient, the potential for a fund manager to outperform becomes less.

Index funds in India are yet to gain momentum. One of the primary reasons for this is the fact that active mutual funds are delivering returns that are better than their respective benchmarks. If one looks at the top 25 equity mutual funds, it can be seen that these funds have delivered 2% per annum return ahead of the Nifty over the past few decades. This can be explained by the fact that mutual funds in India are relatively smaller than the overall market and professional fund managers are expected to do better than retail investors.

Index funds follow a passive investment strategy by replicating a benchmark index such as NSE Nifty or BSE Sensex. The fund consists of stocks in a similar proportion of the benchmark. Thus, it delivers returns similar to the index. In the case of actively managed funds, the fund manager tries to generate a higher return which is measured by alpha. This is one of the explanations why investors don’t see value in index funds in India at the present.

However, index funds have low expenses ratio as there is no need for research and active management. There are also no stock-specific risks as the stocks reflected in the index are established and have a proven track record. Thus, index funds are recommended to investors having long-term financial goals and medium risk appetite.

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