New Delhi, Prateek Oswal. With the increasing popularity of equity investments, mutual funds are becoming a major part of investors’ long-term investments. Among Mutual Funds – Index funds have been increasing in popularity over the past 1-2 years. Passive funds that consist of index funds and ETFs are quite popular in the US and are now gaining the same appeal in India.
What are Passive Funds?
Unlike most mutual funds, where a fund manager is responsible for investing in the underlying stocks, index funds do not need a fund manager. Nifty, Sensex and other popular indices are replicated through passive funds. With the increasing number of Mutual Funds in India – Index Funds provide a simple yet effective solution for long term investments. Passive funds are also cheaper than traditional funds.
With the increasing popularity of index funds – investors should know how to choose the appropriate index funds in today’s time. Although there are limited options – the similarity between fund house to fund can be confusing. What about sector, thematic, international index funds?
What about ETFs?
Invest according to risk profile – Before selecting a fund to invest in, investors should invest according to their risk profile. Most investors chase returns without considering the volatility risk of their investments. This is a risky strategy and often leads to poor investments. For example, a small-cap fund that has given 80% returns in the past is almost never a good investment for a client who wants to grow wealth and is a conservative or moderate investor. Index funds come in various forms ranging from simple large-cap Nifty 50 funds to small-cap index funds, sector funds. Investors should be comfortable with volatility risk before investing in them. A key observation is that investors lose capital not in bad investments but in investments that are not commensurate with their risk appetite.
Index Funds Vs ETFs – Index funds are structured similar to mutual funds. They can be bought daily directly from mutual funds. No demat account is required to invest in index funds and one can set up SIPs easily. ETFs are essentially index funds that are traded on an exchange. Therefore, the ETF’s price is dynamic and tracks the live prices of the underlying stocks – making it effective for investors who wish to trade using the ETF. Both (index funds and ETFs) are equally effective in terms of long-term wealth creation. However, investors should keep an eye on the underlying stock (called iNAV) for price differences and ETFs on exchanges. ETFs are inefficient in India due to the lack of trading on the exchange. Therefore, investors should check the exact price before making a purchase on the exchanges.
When choosing the right index fund, investors may run into the problem of choice, leading to many mutual funds offering the same option. For example – Nifty 50 Index Fund is offered by many mutual funds today. Although most of them are very similar, one important difference is the expense ratio and tracking error.
Tracking Difference – The tracking difference is the difference between the returns of the index and the returns of the fund. It is almost impossible for any fund to completely track or replicate the benchmark. The cost of trading, tax and expense ratio leads to a small tracking error every year. Investors should keep an eye on funds with high tracking error. For funds with similar tracking errors – go ahead with the fund house with the most experience and number of products in passive funds.
Expense Ratio – Index funds are popular because they are cheap. In the long term, there is a positive correlation between expense ratio and tracking error. This means that the lower the expense ratio, the lesser the tracking error. However – investors should not blindly invest in the cheapest index funds. Equally important is the combination of track record and expertise. In many cases – the lowest cost fund does not have the minimum tracking error.
Sector Funds – Sector funds are best viewed in between stocks and mutual funds. Investors looking to make a decision on short-medium term growth of any sector/theme without buying any particular stock can use sector funds properly. They tend to be more volatile and require some element of market timing to increase their effectiveness in a portfolio. Most investors are better positioned to invest in diversified mutual funds for their long-term needs.
International Funds – International index funds are another area of interest. The rupee depreciates by 2-4% every year. Therefore a global fund provides currency protection as well as additional portfolio diversification. And they are a great way to buy stocks like Apple, Google, Netflix and many more. Unlike in India, where both active and passive funds are equally dominant – in a developed market like the US – passive funds are preferred by investors.
Asset Allocation – Asset allocation is where index funds shine. Today investors can build low-cost portfolios using index funds and ETFs. Apart from this, there are good options of passive offering in Debt, Equity, Gold, International – making it easy for investors to build a portfolio.
Lastly – Passive Funds have made life easier for investors in Index Funds and ETFs. With the increasing popularity of index funds and options – it is important that investors take proper steps before selecting the right passive fund.