The advantages and disadvantages of index funds

Given the volatility in the Indian stock markets, many investors are looking at passive investing. Index funds will help. However, they come with some disadvantages.

Kavya Balaji   /   November 17, 2020
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 haven’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 fund’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 manager’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 don’t need to look at parameters such as fund manager’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 an index fund 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 disadvantage is that an index fund 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 aren’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. Don’t know which funds to choose? Ask your consultant at wealthzi.com.

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