Index funds, whether mutual funds or exchange-traded funds (ETFs), are designed to replicate the performance of a specific market index, such as India’s Nifty 50 or Sensex.
In today’s complex investment landscape, index fund investing has surged in popularity as a simple and cost-effective method for accumulating long-term wealth. This article delves into the basics of index fund investing, tracing its evolution both globally and in India, while also shedding light on essential considerations before incorporating it into investment portfolios.
Understanding Index Funds
Index funds, whether mutual funds or exchange-traded funds (ETFs), are designed to replicate the performance of a specific market index, such as India’s Nifty 50 or Sensex. By mirroring the holdings and returns of their chosen index, these funds provide investors with exposure to diverse asset classes, market caps, or sectors without the need for active management. Since these funds don’t require large investment teams, they are typically cost-effective.
The Rise of Passive Funds
The first passive fund was launched by Vanguard in 1975 and tracked the S&P 500 Index. John C Bogle, the founder of the Vanguard Group, helped popularize passive funds. Since then, the popularity of passive funds has surged globally and within India, driven by their simplicity and cost-effectiveness. According to LSEG Lipper, in 2023, global passive equity funds’ net assets surpassed those of active equity funds for the first time, reaching USD 15.1tn, while active fund assets totalled USD 14.3tn by year-end.
In India, passive funds account for about 17% of total MF AUM compared to about 7% five years ago. While EPFO inflows have significantly contributed to the growth of passive funds in India, with approximately INR 7 lakh crores of inflows, excluding EPFO investments, passive funds have still received close to INR 1 lakh crores worth of inflows over the last five years.
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Currently, EPFO is permitted to invest a maximum of 15% of its funds into equities via passive funds. However, discussions have arisen regarding increasing this limit and/or allowing younger individuals to have a higher allocation to equities in their EPF investments. This could lead to further growth in passive fund AUM in coming years.
Evolution of Index funds
Academic research has paved the way for understanding factors influencing market performance, giving rise to smart beta funds. These funds combine passive indexing with active management techniques by choosing stocks based on a single factor or combinations of factors such as value, size, momentum, and low volatility. Globally, smart beta AUM is estimated to be more than USD 2tn and is growing rapidly. In India, smart beta funds are relatively new, with most launched in the past 3-4 years. Presently, their AUM stands at around INR 17,500 crores, but they are increasingly capturing investor interest.
Smart alpha funds are a new approach to investing that use artificial intelligence (AI) and machine learning to identify hidden markets that can help generate outperformance. Smart alpha funds use many data points to try to capture information potentially influencing stock prices before the broader market. While Smart Alpha is still in early stages and will need to demonstrate the ability to consistently outperform, it is certainly an area of interest for market participants.
Debating Passive Fund Bubbles
While passive funds offer obvious benefits such as low costs, the ability to track various market indices and sectors, as well as transparency and consistency, analysts and investors have been debating the potential risks associated with index investing.
Some argue that the rise of passive investing could lead to market distortions. Since passive funds allocate capital based on market capitalization, increased inflows may result in greater investments in already expensive stocks (due to their higher market cap) and reduced investments in cheaper stocks. This phenomenon can be observed to some extent in the current US market, where the so-called “Magnificent 7” mega-cap stocks continue to surge despite their expensive valuations. While there could be several reasons for this trend, one of them could be the significant increase in passive fund flows.
Additionally, active managers typically aim to exploit market inefficiencies, which can contribute to market efficiency, while passive funds may exacerbate existing inefficiencies. However, there is currently insufficient evidence to definitively support this assertion.
Key Considerations for Investors
It is important to recognize that index funds serve as just another avenue to access specific market exposures. Therefore, investors should keep in mind the basic tenants of portfolio construction before investing. These include setting a clear investment objective, which define risk tolerance, return targets, investment horizon, liquidity requirements, and other pertinent factors. The investment objective should then guide the desired asset allocation. Furthermore, diversification across asset class, market capitalization, and sectors are important. Regular portfolio rebalancing is essential to prevent significant deviations from the target asset allocation.
Once an investor has narrowed down the desired index, several factors need to be considered before selecting the right index fund. One primary objective of index funds is cost reduction. Therefore, selecting index funds with the lowest expense ratio is optimal. However, apart from cost, two other factors merit consideration. Firstly, tracking error, which denotes the variance in performance between the index fund and its underlying index. Given that the aim of an index fund is to replicate its chosen index’s performance, a low tracking error is desirable. Secondly, liquidity is crucial, especially for investors using ETFs as opposed to index funds. As ETFs are traded on exchanges, sufficient liquidity helps minimize the impact cost associated with buying and selling the ETF on the exchange.
Conclusion
While index fund investing offers a simple and cost-effective way to build long-term wealth, investors should not overlook the potential for alpha generation in certain segments of the market. For example, in Indian mid and small caps are still significantly under-researched, thus providing a lot of information asymmetry that active managers can exploit. Historically, mid and small-cap funds have demonstrated strong alpha generation ability. Therefore, investors should conduct thorough research before investing in index funds.
Ultimately, staying disciplined, maintaining a long-term perspective, investing regularly, and adhering to a well-thought-out investment strategy remain the key to achieving long-term wealth creation.
Happy Investing!
(By Alekh Yadav, Head of Investment Products, Sanctum Wealth)
Disclaimer: Views and facts expressed above are those of the author. They do not reflect the views of financialexpress.com. Please consult your financial advisor before making any investment.
