Should You Invest in Index Funds for Long Term

Index Funds was first introduced by John C Bogle in 1976 and are one of the most popular investment options in developed countries. Its popularity can be gauged by the fact that index funds control almost 30 per cent of the US stock markets. But in India, index funds are the most underrated mutual funds and yet to gain any momentum.

Compared to any other equity mutual fund categories, index funds are pretty simple and have a basic structure. The fund tracks and matches the holding of a particular market index, with a well-diversified group of quality stock across various sectors that represent the index.

The main argument given by John C Bogle for launching this category of the fund is that, over the long term, fund managers are unable to beat the average market returns, hence the additional risk taken by actively managed funds is unjustifiable.

So, despite being a much-celebrated fund category, why index funds is not a hit in India?

There are many factors, which keep investors away from the index funds in India, and the primary one is investors’ lack of knowledge about the fund category. And, investors prefer to go for funds with higher returns, which are only offered by actively managed funds.

Also, Indian financial market is still not as mature as other markets and there are some basic structural issues in the fund category. Indian indices rejig their composition too often, which makes it difficult to run a good index fund. Further, there is a significant deviation in returns from their benchmark. Which means, funds at times are being actively managed to churn higher returns, which goes against the fundamental interest of the fund.

Should You Invest in Index Funds

Passive investing has many advocacies over active investment. William Sharpe, Nobel Laureate, known as the father of the Capital Allocation Pricing Model has said, one cannot beat the average market returns consistently year after year. And, after deducting the overall costs, the net returns of active funds are less compared to any passive funds over the long term.

William Sharpe’s rule to a good investment is to have a well-diversified portfolio while keeping the costs at lowest. And, an index fund helps with both the features. Because index funds mimic a particular index, the fund manager need not have to pay for costs on research and trading, which helps in keeping the overall fund cost low.

Now, if we take the example of both Nifty and Sensex, in the last 10 years, it has generated a CAGR of 15.76% and 15.57% respectively.

More particularly if we check the Nifty CAGR returns of the last five years (May 2014-May 2019), it would be astonishing 12.32 per cent. Despite some major economic shocks ( Demonetisation, the introduction of GST, the unfolding of PNB scam), the index managed to generate a double-digit return.

Thus, investing in index funds make sense over actively managed funds which carries a greater degree of risk and costs, in order to generate that much return.

Tracking Error

The returns of index funds are always lower compared to the target index and the reason is tracking error.

Tracking Error = Standard Deviation

Although index funds mimic a particular index, there is a certain degree of deviation in returns compared to the target index. The primary reason for the deviation is the expense ratio, cash holdings, changes in index composition etc.

Tracking error helps investors to evaluate the fund and forecast its performance. Funds with large tracking error signify some structural and fundamental issues and are best to avoid.

Returns Comparision in Equity Funds

Fund Type1 Yr Return (%)3 Yrs Return (%)5 Yrs Return (%)10 Yrs Return (%)
Large-Cap Equity Fund8.4112.219.5811.27
Mid-Cap Equity Fund-1.028.3111.4816.57
Small Cap Equity Fund-4.467.9311.9615.45
Nifty Returns7.312.7512.3215.76

Returns as on 8th July 2019

Top Index Funds

Funds1 Yr Return (%)3 Yrs Return (%)5 Yrs Return (%)10 Yrs Return (%)
UTI Nifty Index Funds8.2712.599.6311.43
HDFC Index Funds- Sensex Plan9.2513.469.6511.50
ICICI Pru Nifty Index Funds7.5111.779.0211.43
SBI Nifty Index Funds7.7212.048.9011.02

Returns as on 8th July 2019

Conclusion

Despite several issues and unpopular investment option in India, investing in an index fund is a profitable idea, if done with a long term view ( preferably over five years).

Index funds don’t tend to beat or outperform the market returns, but it tries to provide closer to market returns. Thus by investing in index funds, you ride with the market wave and is also a less risky option. On the other hand, actively managed funds try to outperform the market and are not consistent with returns over the long run.

And, if we go by the world indexing leader, Vanguard, which manages over $3 trillion in assets in index mutual funds and ETFs, out of its 139 index funds in different asset category, 117 funds have outperformed their Lipper peer-group* averages in 10 years period.

*Lipper Average represents the average annual return of a fund among its peers

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