Index Funds Archives

How are Index Funds different from Exchange Traded Funds

It’s quite possible that you’ve heard of ETFs, but have no idea what they are. Or, you may know that they are index funds but may not understand the differences between them. Hopefully, by the end of this article, you will have a good grasp of the basic differences between ETFs and Index Funds and how different situations would suggest investing in one over the other.

But first, let us understand what Index Funds and ETFs are.

You must have heard or invested in some of the mutual funds that are very popular in the financial media space. There is a high probability that the widely talked fund is an active fund. An active mutual fund is a fund that the fund manager actively manages. On the other hand, passive fund managers don’t make investment decisions. These funds track the underlying benchmark index, such as BSE Sensex or Nifty 50.

Passive funds can be categorised into two types: index funds and Exchange Traded Funds. While ETFs can be active as well, in India, ETFs are generally passive.

What is Index Fund?

The structure of an index funds is like an open-ended mutual fund. The main objective of the index fund is to provide returns as per the returns given by the benchmark index. Its goal of these funds is not to beat the index.

What is ETF?

ETFs or Exchange Traded Funds, which are a basket of stocks or investment instruments, are listed and traded on the stock exchanges. As a result, ETFs have characteristics similar to stocks while Index Funds are like mutual funds.

Also the ETF price behaves like stock price during the market hours. Index Fund on the other hand declares net asset value like for a mutual fund every working day.

As we have mentioned earlier, investing in ETFs is like investing directly in stocks, so just like you would need a demat account to invest or trade in the stock market, you will need a Demat account to invest in an ETF as well.

However, you donâ€™t need a Demat account to invest in an Index Fund.

SIPs: Systematic Investment Plan (SIP) is the most convenient and disciplined way to invest in mutual funds. However, the facility to invest through SIP is only available for index funds. Onetime investment or lumpsum is the only way to invest in an ETF.

Unit Price: As ETFs are traded on the stock exchanges, the price of one unit of ETF will change throughout the day. So, if you want to buy a unit of a particular unit, the price of that unit will depend on the demand and supply. However, in the case of index funds, the fund houses will calculate the daily Net Asset Value (NAV), which is the unit price of the index fund.

Liquidity: One of the major differences between ETF and index funds is liquidity. If an ETF is not highly liquid, i.e., the daily average trading volume is low, you might face some problems while selling your ETF units as you have to sell your ETF units directly to another investor.

However, this is not the case with index funds. You need not look for an investor as the fund house takes care of your redemption.

Total Expense Ratio (TER): ETFs and Index funds have a Total Expense Ratio (TER). TER is the fee that a mutual fund house charges for managing your investments. However, ETFs have a lower expense ratio than index fund.

Tracking error: Exchange Traded Funds(ETFs) are more likely than Index Funds to have a lower tracking error, which implies ETFs can more closely track an index. This is because Index Funds are required to keep some cash on hand at all times to meet redemption requests. A mutual fund house has no such requirement with ETFs.

Conclusion

Both Index Funds and ETFs are a great passive investment options to invest in the market without being required to pick specific stocks.

We covered many essential differences between index funds and ETFs. Besides this information, you should always consult a financial adviser before making any financial decisions.

Best Index funds of 2021

An index fund is a kind of mutual fund that constructs its portfolio by tracking the composition of a standardised market index. This could be any of the benchmark indices in the stock market such as the Nifty 50 or the Sensex.

Note that the index fund will not only invest in the stocks as those the index invests in, it will also maintain the ratio in which the index has invested in these stocks. For instance, in the Nifty 50 the weightage for HDFC Bank is 10.29% while that of Infosys, it is 7.81%. An index fund that follows the Nifty 50 will allocate the same weightages to these stocks in its portfolio. So, the index fund doesnâ€™t make investment calls on its own, it just imitates the index.

The aim of an index fund is to replicate the performance of an index in terms of the returns that the index generates. This replication is done at a minimal cost. This is the reason why index funds are also called passive funds. They are not actively managed. The fund managers do not make any buy and sell calls. So, there are no transaction costs. Naturally, the expense ratio and other fees for managing index funds are much lesser than those of actively managed funds. This makes index funds cost-efficient.

Read this article to know more on index funds â€“ How are index funds different from large-cap funds?

Best index funds to invest in 2021

If you are looking to invest your money in index funds, you can consider the following list of the best index funds in India that have done well in the past.

LIC MF Index Sensex Fund

Launched in 2002, this fund has a good track record of closely following the market index S&P BSE Sensex. The fund has no entry load while the exit load of 1% is applicable only if you redeem within a month. As of 3^rd February 2021, the NAV of the fund (dividend option) was Rs 32. The expense ratio of the fund is 1.08%. The fundâ€™s five year Compounded Annual Growth Rate (CAGR) return is 15.55%. The three-year return is 12.8% while the one-year return is 26.22%. If you had invested Rs 10,000 as monthly SIP in the fund for the last three years, your corpus will be Rs. 4.81 lakh.

ICICI Prudential Nifty Index fund

This fund has been a part of the index fund category for close to two decades. It was launched in 2002. So, the fund has managed to garner more than Rs 1,217 crore of Assets Under Management (AUM). The fund closely follows the Nifty 50 Index. The fund has no entry load or exit load. As of 3^rd February 2021, the NAV of the fund (dividend option) was Rs. 19.14. The expense ratio of the fund is low at 0.45%. The fundâ€™s five-year CAGR return is 15.34%. The three-year return is 11.62% while the one-year return is 26.53%. If you had invested Rs. 10,000 as monthly SIP in the fund for the last three years, your corpus will be Rs. 4.76 lakh.

HDFC Index Sensex fund

This fund was launched in 2002 and has AUM of more than Rs. 1770 crore. The fund closely follows the S&P BSE Sensex. The fund has no entry load while the exit load of 0.25% is applicable only if you redeem within three days of purchasing the fund units. As of 3^rd February 2021, the NAV of the fund was Rs 448.49. Note that this fund doesnâ€™t have a dividend option. The expense ratio of the fund is very low at 0.30%. The fundâ€™s five year CAGR return is 16.58%. The three-year return is 13.41% while the one-year return is 26.56%. If you had invested Rs. 10,000 as monthly SIP in the fund for the last three years, your corpus will be Rs. 4.83 lakh.

UTI Nifty Index Fund

This fund is one of the oldest funds in the index funds category. It was launched in 2000 and has AUM of more than Rs. 3,173 crore. The fund closely follows the Nifty 50 Index. The fund has no entry load or exit load. As of 3^rd February 2021, the NAV of the fund (dividend option) was Rs. 49.17. The expense ratio of the fund is one of the lowest at 0.14%. The fundâ€™s five-year CAGR return is 15.96%. The three-year return is 12.17% while the one-year return is 27%. If you had invested Rs. 10,000 as monthly SIP in the fund for the last three years, your corpus will be Rs. 4.79 lakh.

SBI Nifty Index Fund

This fund was launched in 2002 and has Assets Under Management (AUM) of more than Rs. 950 crore. The fund closely follows the Nifty 50 Index. The fund has no entry load while the exit load of 0.2% is applicable only if you redeem within 15 days of purchasing the fund units. As of 3^rd February 2021, the NAV of the fund (dividend option) was Rs. 65.04. The expense ratio of the fund is 0.48%. The fundâ€™s five-year CAGR return is 15.31%. The three-year return is 11.44% while the one-year return is 25.98%. If you had invested Rs. 10,000 as monthly SIP in the fund for the last three years, your corpus will be Rs. 4.74 lakh.

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The advantages and disadvantages of index funds

Every investor who is starting to invest in mutual funds is told that large cap funds are the ones to start with. However, the truth is that these funds havenâ€™t provided investors with good returns this year because of the pandemic and other economic reasons. Mid cap and small cap funds seem to have done much better than the large cap ones. This may be one of the reasons why beginners and low risk mutual fund investors want to choose passive investing such as investing in an index fund.

What is an index fund?

An index fund is a mutual fund that invests in the same set of stocks as in a chosen index and in the same weightage. This means the mutual fund will closely follow the index and the returns will be as per the index movements.

However, there could be a small difference in the returns of the mutual fund and the index. This is called the tracking error. Tracking error shows a mutual fundâ€™s consistency versus a benchmark index over a given period of time. Even mutual funds that seem rightly indexed against a benchmark index may behave differently than the benchmark. That is why investors need to always look for an index fund with the lowest tracking error. If the index fund is providing low average returns and has a large tracking error, you will need to understand that the index fund is not the right one.

What are the advantages of index funds?

The main advantage of index funds is that they are relatively low-risk options when compared to other equity funds. This is because there is no fund manager involved who takes investment decisions. Your returns will be wholly based on the market.

Another advantage of index funds is that they are inherently diversified. This is because they represent several different sectors within an index. Even in case of diversified, actively managed equity funds, there might be sector concentration depending on the fund managerâ€™s decisions. However, for index funds the weightage for the stocks will be across different industries. So, your portfolio will remain safeguarded from sector concentration.

The third advantage is that index funds could provide good returns over a longer time horizon. If you look at the Nifty and the Sensex in the past decade, they have provided good returns. The Sensex has provided investors with 63.07% in five years and 103.5% in ten years. Nifty has given 57.43% in the past five years and 97.75% in ten years. So, you could get good returns by investing in index funds for the long run.

Another primary advantage of index funds is the low expenses incurred by these funds. Index funds come with a low expense ratio. Actively-managed funds come with higher expenses because the fund manager manages the portfolio and trades in securities. Transactions costs for an actively managed fund are higher. A low-cost index fund allows you to invest in the stock market without spending much money. The low expense ratio also means that the returns you get from the index fund will be higher.

Index fund also come with the advantage of easy tracking. You donâ€™t need to look at parameters such as fund managerâ€™s expertise, alpha wtc, for investing in an index fund. As long as the tracking error is low, you can invest in an index fund. Tracking the stock market is enough to track the fund.

What are the disadvantages of index funds?

The main disadvantage of index funds is the lack of flexibility. Fund managers of index funds cannot invest in different stocks when there is a market downturn. So, the losses cannot be limited by investing in stocks other than the ones in the index. However, actively managed funds can choose to invest in stocks with different market capitalisations, especially when the markets are volatile. This helps improve returns and limit losses.

Another major disadvantages is that index funds cannot beat market returns. They will either provide returns equal to that of the market or slightly lower than that of the market. If you want returns that are much higher than that of the market, you will need to invest in actively managed mutual funds.

Should you invest in index funds?

Index funds arenâ€™t recommended by financial advisors because in India, more than 75% of the fund managers are able to provide returns that are much higher than that of the market. This is unlike the developed markets where only a handful of fund managers are able to do that. So, the returns from actively managed funds such as midcap and small cap funds are much higher than that of index funds.

The recent decent performance of index funds versus large cap funds is because of the market rally. However, passive funds may not beat active ones in the long run. Several actively-managed funds continue to beat their benchmark by a wide margin. Investors should look at actively managed funds if they need higher returns. Donâ€™t know which funds to choose? Ask your consultant at wealthzi.com.

How to invest in mutual funds for financial goals

You might have heard financial experts tell you that you can invest in mutual funds for goals such as your retirement or your kid’s education. This is because over long periods, equities have the potential to outperform every other asset class. However, you can use mutual funds for short term goals like saving up for your dream vacation or that SUV you always wanted to buy. Here’s how to invest.

The basics

While drawing up a mutual fund portfolio, keep these basic rules in mind: know the broad categories of schemes in the market, their purpose and how they work. For instance, knowing the difference between income funds and gilt funds—where they invest, their portfolio and what kind of returns they are likely to generate- will help you choose the right fund.

Ensure that the mutual fund you choose matches your risk profile and investment objective. Let’s say you know that you need to invest in equity mutual funds for your retirement. However, you have a low risk appetite. In that case, you will be better off investing in index funds rather than actively managed mutual funds. So, respect your risk-taking capacity. Do not go overboard on equities if you are not comfortable taking on the risk.

Earmark funds for each of the goals. Let’s say you are investing in ELSS mutual funds for your kid’s education that is 15 years away. ELSS funds have a lock-in period of 3 years. Once the lock-in is done, ensure you reinvest the money in another investment. Linking your investments to your goals will help ensure that you don’t use the money for other purposes before you achieve the goal.

As you move closer to your goals, start moving your money from equity mutual funds to debt oriented mutual funds. Say your kid is in class 10 and will go for engineering course after he completes schooling. Since you have only two years in hand, you should choose debt-oriented funds such as bond or short-term funds that will be available at any time. You also preserve your capital gains from equities if you move to debt mutual funds.

The ideal way to build an adequate corpus for your goals is to go step by step. Earlier you start, the better money you will be saving. Of course, you also need to stop along the way occasionally to make sure things are happening as planned. The closer you get to your destination, the more careful you need to be.

Choosing the fund

Have a mix of large- medium- and small-cap equity schemes if you are investing for long term goals. If you will need the funds in about 8-9 years from now, opt for mid and small cap funds. However, if the goal is five years away, you may want to stick to large-cap funds as they invest in well-established, top-rung companies and are, therefore, less volatile. They give reasonable gains when equity markets rise and are also comparatively less volatile when equity markets fall.

High risk funds like thematic funds can be considered to get the kicker in returns only if you have a higher risk profile. The idea is to take the equity advantage and yet control the risks you take. Choose well-performing equity schemes with established track record.

If you are investing for the short term which is more than one year, choose from a range of income funds, credit risk, dynamic bond funds, duration funds and bond funds. If you can take higher risks, you can invest in thematic debt funds such as Sundaram Banking & PSU Debt Fund. If you need to invest for less than a year, you could invest in liquid funds and short-term debt funds.

Diversification across funds

Diversify across and within mutual funds. Don’t diversify for the sake of diversification or over-diversify within asset classes. You can invest in up to three schemes in a category at most. Remember, one of the reasons you have opted for mutual funds is because you do not want to spend a lot of time on your investments. But you might spend more time on your mutual funds if you scatter your money across too many schemes. The rule holds true whether you are investing in the equity or the debt market. If you invest in too many schemes with the same or similar style, you could end up investing in same stocks through multiple funds. Even though there is no fixed number as to how much one should hold in one’s portfolio, it can be at the most 7-10 schemes. This makes it easy to manage your portfolio.

Portfolio review

If you think that your job is done once you have put your money in mutual funds, think again. Your portfolio may contain star performers, but just a couple of oversights could affect their performance. So, track your scheme’s Net Asset Value (NAV) on a monthly/quarterly basis. Look for changes in the scheme’s portfolio. Compare the scheme’s performance with that of the benchmark, or similar schemes of other mutual funds. Ensure that the fund is adhering to the fund objectives stated in the offer document. Read all those various periodic statements such as newsletters, and half-yearly and annual reports. Make sure you track your fund at least every 18-24 months.

Choosing the right mutual funds for each of your goals will help you achieve them without hassles and in right time.

How are index funds different from large-cap funds?

Over the last couple of years, there have been talks about how index funds are performing better than actively managed mutual funds. First, let us look at why some of the large cap funds are just not able to beat the benchmark index.

Index fund vs large cap fund

A few years back, the Securities Exchange Board of India (SEBI) recategorised mutual funds. Why? This was to make sure that different schemes launched by mutual fund houses are clearly distinct in terms of asset allocation, investment strategy etc. Further, this was to bring in uniformity in the characteristics of similar type of schemes launched by different fund houses. This was to help investors to evaluate the different options available before taking an informed decision to invest in a mutual fund.

After the categorisation of mutual funds, large-cap funds had to invest a minimum of 80% of their portfolio in the top 100 stocks as calculated based on the market capitalisation of the stocks. Due to this, large cap funds are struggling to beat the benchmark index that is available at a lower cost. Note that before the recategorisation, several large-cap funds could take exposure to mid- and small-cap stocks and this helped them generate higher returns.

Now, what are the differences between index funds and large cap funds?

Large cap funds are actively managed funds. Funds where the fund manager decides which companies to invest in based on their research are called actively managed funds. All large/mid/small cap funds are actively managed funds.

Index funds are passively managed funds. Funds that track or mimic the composition of an index are passively managed funds. The index could be Nifty 50, Nifty Midcap 100, BSE Small cap, etc. For example, an Index fund tracking Nifty 50 will invest in all the 50 companies on the Nifty.

So, in a large cap fund, the fund manager decides which stock or sector to invest in. An index fund just tracks the benchmark index. There is no market research or intelligence involved here.

Since market research skills are needed for large cap funds, these funds have higher expense ratio compared to index funds. The biggest advantage of an index fund over a large-cap fund is its low cost. Fund management cost of an index fund can be as low as 0.17% whereas large cap funds charge anywhere between 1.5% to 2.25% as fund management charges.

Then, come the fund performance. Note that if the large cap fund manager’s views are right, the fund will generate higher returns or will outperform the benchmark. However, if the views don’t turn out to be right, it can lead to lower returns or under performance. For index funds, the returns will mimic that of the index.

The volatility of the index funds is generally comparatively lower than that of large-cap funds.

Who should invest in large cap funds?

Investors with a low level of risk tolerance can consider large cap funds. Investors who belong to the elderly age group or those who are nearing retirement should consider adding large cap funds to their portfolio. Even those who are looking at income can consider large cap funds with a good dividend history. The steady flow of dividend acts as a stable source of income. Investors with a long investment horizon and looking to invest for long term goals could channel their investments towards large cap funds. When compared to mid-cap funds and small cap funds, large cap funds are less risky.

Who should choose index funds?

First time mutual fund investors can consider index funds. It is a good way of getting introduced to the market at lower costs and lower risks. Those investors who are nearing their age of retirement could consider Index funds. Investors with low risk profile and limited capital can try index funds.

What’s the buzz in the marketplace?

With several large cap fund managers mimicking the benchmark index, wealth managers and other financial experts feel investors can make large cap allocation using low cost index funds. In these, fund managers don’t hold on to cash and there is no fund manager bias.

There are others who are saying that if you are going for an actively managed fund it is best to choose multi cap funds rather than large cap funds. Why? This is because these funds have the flexibility to choose stocks across the large cap, mid cap and small cap categories. So, while risk-averse investors can choose index funds, those with a medium or high-risk appetite could consider focused funds as part of their large cap allocation. If you are not sure about which fund suits your risk profile, financial situation and life goals, get in touch with your consultant at wealthzi.com.

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What is an index fund?

What are the advantages of index funds?

What are the disadvantages of index funds?

Should you invest in index funds?

The basics

Choosing the fund

Diversification across funds

Portfolio review

Index fund vs large cap fund

Now, what are the differences between index funds and large cap funds?

Who should invest in large cap funds?

Who should choose index funds?

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