Index funds: How they can be a better instrument over Mutual Funds
Over the years I have got exposed to the idea of Index Funds through reading some books and following the advice of celebrity investors on social media.
An index fund is a type of mutual fund or exchange-traded fund (ETF) that aims to replicate the performance of a specific market index, such as the S&P 500 in the U.S., the FTSE 100 in London, or the Sensex 30 or Nifty 50 in India.
Unlike the actively managed funds, which rely on the expertise of fund managers to select individual stocks, index funds passively track the composition and performance of an underlying index.
Now the question arises what is an Index? An Index is a benchmark for evaluating the performance of an investment portfolio. In India, we have 2 major Indices- Sensex 30 and Nifty 50. In Sensex 30, we have the top 30 companies by market cap (Share price X No. of shares) listed on the Bombay Stock Exchange, and for Nifty 50 it is the top 50 companies by market cap listed on the National Stock Exchange.
Now Index funds are like Mutual funds, run by professional companies who invest the money of investors in these top companies and thus try to replicate the returns of the Index as a whole. If the Index goes up, the investment goes up. One just needs to know the Sensex returns to know how their portfolio has fared. In actively managed Mutual Funds, the returns may be independent of the Index performance.
Unlike Mutual Funds, Index funds do not need the active participation of the fund managers. In actively managed Mutual Funds, the managers bring in their expertise to choose particular stocks which they feel will do well. These stocks may not even be from the top 30 or 50 companies and thus the returns will not necessarily replicate the Index.
The major differentiator between Index Funds and Mutual Funds is the Expense Ratio. It is the amount of fee charged for managing a particular fund. It is naturally high in actively managed Mutual Funds in which managers bring in their expertise. It is the least for the Index Funds which do not need any intervention from the managers once the investment is made in companies that form the Index.
The rationale that makes investing in Index Funds a good idea is the predictable long-term growth. Stock markets have delivered a positive growth trend in the past century. The S&P 500 index of the U.S. stock market has delivered a return of around 10% since 1930. This does not mean that the returns were constant at 10 % every year. 10% return is the average return over the years. This period includes severe downturns and high rates of growth cycles in the stock market such as the 1930 depression, the 1999 tech crash, and the 2008 financial crisis.
According to the S&P Indices Versus Active Funds (SPIVA) India Scorecard for 2022 report, about 88 percent of the actively managed large-cap equity funds have underperformed their benchmark S&P BSE 100 index in 2022. This number is even higher in the U.S. stock exchange where 95% of the funds have historically failed to beat the Index.
The reason for the subdued growth is the hefty transaction fees levied by the actively managed Mutual Funds at each stage of the transaction. Various charges levied by the mutual fund houses are:
Expense Ratio: It is the annual expenses of the mutual fund, including management fees, administrative costs, and other operational expenses. The expense ratio is expressed as a percentage of the investment amount an investor puts into the fund.
Exit Load: An exit load is a fee charged when an investor sells or redeems their mutual fund units within a specified period. The exit load varies from company to company and is a percentage of the redemption value.
Transaction Charges: These charges are levied on the purchase or sale of mutual fund units and are typically a small percentage of the transaction value.
Other Charges: There may be other charges applicable in certain cases, such as switch charges for switching between different schemes within the same fund house, dividend distribution tax on dividend payouts, etc. These charges vary from fund to fund and are usually disclosed in scheme-related documents.
Now if you add up all these expenses the Expense ratio comes out to be a sizable amount that eats into the returns the fund generates. The average Total Expense Ratio of popular Mutual Funds in India ranges anywhere between 2-3%. This means that this amount will reduce an assumed 12% return by 2-3% points. Thus, the overall return is reduced from the returns of the fund. Investors lose the portion of returns to these fees levied.
This is where the Index Funds win in terms of actual and delivered returns. The Expense ratios in Index Funds are minimal. In a few Index Funds in India, it is as low as 0.05%. Assuming the Index grows at 12%, the return of the Index Fund which mimics the Index is around the same after deducting the minimal expense ratio.
This is not to write off all the actively managed Mutual Funds. There are good managers of Mutual Funds who sell their products well but also deliver on what they claim. They beat the Index and generate alpha- which is the return above the return of the Index. If you are lucky to find such funds or managers, you may have better returns than investing in Index Funds.
The problem with Mutual Fund companies is that the managers change jobs. So, a fund manager whom you trusted may not continue in the fund for various reasons. You are then in the hands of a guy whom you may or may not trust. Another factor is that the manager may even fail to beat the Index on a short-term horizon.
If you do not have the patience to stay invested for the long term, then you should not bother with either a Mutual Fund or an Index Fund. The Stock market may deliver you short-term returns through Day trading, but it is inappropriate to expect returns from funds in the short term.
Remember, the 10% yearly return since 1930 is on a long-time horizon. Had you cashed out in the very next stock market crash you may have lost your wealth. The beauty of the stock market is in the long run when you do not touch your portfolio and let it ride the waves of the stock market.
Index fund investing is not yet popular in India as compared to the West. Warren Buffet was asked a question as to what advice on investing he would pass on to his family after he is gone. He replied that he would tell them to put their money in the Index Fund and stop bothering about individual stocks. Buffet believes in the simplicity of the Index Funds and knows that it is a challenge for most fund managers to even beat the Index. Buffet suggests this method of investing for anyone who does not have time to study individual stocks and make a calculated decision on investing in them.
Picking up your portfolio is no easy game. I started the journey around 4 years back when I bought my first stock of Hero Mototcorp. Then when the stock market crashed in 2020 due to COVID, I got the courage to invest deeply in my watchlist. The COVID lockdown provided an opportunity to study and analyze annual reports to shortlist the companies.
After investing a sizable portion of my savings in the stock market, I enjoyed looking at the gains of the stock market. I felt as if I had mastered the art of investing and now nothing could stop me to grow my wealth. I along with my friend even predicted the next crash and saved some capital to deploy at the bottom. The crash never came, the gains stopped after a while. The market stabilized and my portfolio did not move. Then certain stocks in my portfolio took a hit.
I realized I could not keep pace with the analysis of my portfolio on a regular basis. After the lockdown, I got busy with my job and thus could not take out time to study the reports. I realized it was not easy to continue doing it. Also, my returns on the portfolio were no more than the Index returns.
I decided that I should rather invest in Index funds and deploy my energy on other stuff. It is not that I do not like reading balance sheets or analyzing companies, it is that the return on the time and energy invested is not impressive. I am satisfied if the stock market gives me a 10% annual return in the long run.
A 10% return on Rs. 1 lac invested for 15 years will return Rs. 4.04 lacs, i.e. 4x the investment. If you invest the same amount in a Fixed Deposit in the Bank that gives an assured 5-6% return, you end up with Rs. 2 lacs which is just 2x the investment.
However, it should be noted that past returns are no predictors of future returns. A 10% return is not assured on the stock market. The returns depend on the economic conditions and growth of the country. The stock markets run on sentiments that can go in either direction. So, one should never place emphasis on past returns to predict how well they would do in the future.
Another drawback to investing in Index funds is the limited Upside potential to the return. Index funds aim to replicate the returns of a specific market index, so they won't outperform it. If you are seeking higher returns than the market average, actively managed funds or individual stock selection might be more suitable.
One should study their risk horizon and then take a calculated call. It is not advisable to invest all your savings in the stock market. One can have a basket of investments including the bank F.D., debt instruments, real estate, or the PPFs. But for folks who trust the nation’s economy and future growth potential, investing in Index funds can provide a better return than traditional investment instruments.
How my journey of investing started!
My exposure to Mutual Funds was through my Mother who is a Banker. She understood the concept of saving money well. My Mutual Funds were opened in SBI, the bank where she works, by letting me know that it was a good idea and I should sign the papers.
Without knowing what to expect, I signed the papers and generated my monthly SIP. Every month the SIP took away a sizable portion of my salary. In the early days of my job, there was always a shortage of money owing to excessive spending, partying, and traveling. I always became furious at my mom for pushing me into an investment that depleted my bank balance. There was a moment when my account got zero and I needed the money badly. I immediately told Mom that I don’t need the SIP and it should be stopped immediately. She did not budge then, thankfully.
Now, I have a sizable amount of investment in these funds but the returns have been suboptimal. Surprisingly, I have not been able to stop that SIP 9 years after I started it. State Bank of India has the most pathetic customer care possible. I have written to them multiple times to stop it. They never respond to emails or my applications. I think they want my physical presence to stop the SIP. What a mockery in this digital age. This is the reason that it is continuing to date. One day, I will definitely go and stop it. Hope it is not 25 years down the line. I also hope they give me some returns for my patience throughout these years.
