Markets nowadays are rallying too much, aren’t they? There is not only heavy volatility due to the pandemic but there is also fear amidst the investors. So every investor seems to be set on a voyage to locate the best possible way to keep their capital safe and increase their returns. Before we look into index funds, why index funds make sense etc, I think it’s important to know a little history about how index funds came to be.
History
The story of how the first index fund came to be is quite fascinating. John C. Bogle, also known as Jack Bogle, the founder Vanguard, launched the first index fund in 1976. The fund was called the First Index Investment and tracked the S&P 500 Index. The fund was later renamed as the Vanguard 500 Index Fund. For context, the S&P 500 consists of the 500 biggest US companies, and the index is a market capitalization-weighted. Meaning, the total free float outstanding shares of a company are multiplied by its price and higher the value, higher the weight of that stock in the index, and it’s that simple. Nifty and Sensex follow the same methodology as well minus a few technicalities.
Do index funds work?
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. You may be wondering given that index funds just track a benchmark and not seek to outperform, how do they even make sense, it’s a fair question. Outperformance is always better than just benchmark returns, right? Let’s unwrap this. Markets are a zero-sum game, meaning that for every person making money, somebody has to lose money. This means that all active managers collectively cannot beat the market. The reason is cost, and they are the biggest drag on the performance.
Let’s compare the expense ratios of active large-cap mutual funds and index mutual funds. Before moving to the comparison, expense ratio is a small percentage of the total assets of the fund charged by the fund house towards fund management services. Moneycontrol shows as on 16th March the category average expense ratios, which allows you to quickly get a sense. The category average expense ratio of Nippon India large-cap mutual funds (direct plans) is 1.13%. Whereas UTI nifty index fund has a category average of 0.3%. That’s almost 1% difference. Though this might seem small, costs compound over a long period and significantly eat into your returns.
Index funds are extremely cheap. The reason why index funds are cheap is that they don’t need highly paid star fund managers, research teams etc. All they have to do is copy an index, and that’s it.
Drawbacks
Lack of Downside Protection
The stock market has proved to be a great investment in the long run, but over the years it has had its fair share of bumps and bruises. Investing in an index fund will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside.
Price Discovery Go For a Toss
When herd of people start investing in index funds, it brings huge amount of funds in the scheme. It keeps the price inflated for a very long time. The inflows of supplementary money keep the price high which makes the price discovery go for a toss.
Tracking Error
Tracking error is the difference between the actual performance of the index and the actual performance of the funds. The index funds must adapt to the same path as the market index. Any differences in the same will be termed as tracking error.
Bottom line
There are risks and benefits of index funds that investors should be aware of prior to investing. While index funds can be smart choices for most investors, they may not be right for everyone.
Index funds are passive funds, where entry and exit points matter. To deal with this pointer we suggest active management closely following the market valuation. Follow this link for more information:
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