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Should you invest in index funds?

While Indian equity markets are moving towards efficiency, fund managers still have a role to play.

Sometime in 1976, a little-known person then named John Bogle introduced Vanguard 500 index fund, the first index fund ever. He believed it would be difficult for actively-managed mutual funds to outperform an index fund once management fees, operating expenses, sales commissions and other related costs are subtracted from returns. His goal was to give investors a fair share of the stock market’s return by offering a diversified equity fund that keeps its expenses low. 

While the financial community was sceptical, over the years, Vanguard assets grew massively in size to surpass those of active stocks in 2019 in the US. 

Does it make a strong case to invest in index funds back home?

An index fund is a passively managed fund – there is absolutely no human intervention in picking or selling of stocks. It blindly mimics the stocks of its benchmark index and that too in the same proposition as its weight in the index. 

Exchange-traded funds or ETFs also track indices and are usually cheaper than index funds. Their fund-of-fund option also allows its buying and sale at end-of-the-day NAVs through a mutual fund house instead of the exchanges.

However, index funds haven’t gained much popularity in India. Some are based on market capitalization (large-cap, midcap), few others focus on international indices or sectors. The new kid on the block is the smart beta fund which tracks a traditionally popular index – Nifty 50 or Nifty 100. 

Extent of Outperformance

In the last 10 years in the US, only about 10-20 per cent of actively managed equity funds have managed to beat their benchmark indices. Higher expense ratios, the constant influx of institutional money into index stocks, and efficient stock market (stock prices reflect all available and relevant information) have arguably left little scope for active managers to outperform. 

However, in India, over the last 10 years, 46 per cent of actively-managed large-cap funds managed to outperform its benchmark (S&P BSE 100 TRI) while it was 60 and 81 per cent for multi-cap and midcap funds respectively. 

The average annual expense ratio of actively managed equity funds is high at about 2.25% in India, while index funds and ETFs charge up to 1 per cent annually. Yet, actively managed equity funds managed to outperform their benchmark indices.

Since Indian stock markets are still at a nascent stage relative to developed markets, it seems that equity fund managers are still able to dig out more information and discover stocks that deliver market-beating growth. It has happened more so in the midcap and small-cap space as against the widely-tracked large-cap stocks. 

Moreover, some tactical shifts made a difference. For instance, when the Sensex was continuously tanking from the highs of 41,000 to 26,000 this year, some equity funds upped their cash levels or cut exposure to vulnerable sectors to minimize the losses. 

 Investment strategy

Index funds can be a low-cost way to enter equities. In the last 41 years, Sensex has moved 378 times to 37,800, giving a CAGR of return of 15.5 per cent to its investors. While history might not repeat itself, investors can reasonably expect about 10-12 per cent from equities going ahead.

Among indices, large-cap index funds are worthwhile from a long term perspective – given the wide choice as well as the comfort of owning blue-chip stocks. 

However, do remember that many active Indian fund managers have been able to outperform the index.

Takeaway

While Indian equity markets are moving towards efficiency, fund managers still have a role to play. There is still scope for earning higher growth than the market/index by investing in a reliable equity fund – the SIP way. 

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