Are Index Funds the Right Choice for You?
Table of Contents
What Are Index Funds and How Do They Work?
Index Funds are an investment instruments that are based on stock market indices like Sensex or Nifty. These indices are built on the basis of the free-float market capitalization of biggest companies in India. The purpose of an Index Fund is to imitate the exact portfolio of the index that it is tracking, i.e., a Sensex Index Fund will hold all the 30 companies that comprise the Sensex in the exact same proportion of weights they have in Sensex.
Index Funds could be in the form of an ETF (Exchange Traded Fund) or in the form of a Mutual Fund. Each have their own advantages and disadvantages, you can read more about them here. In India, majority of the Index funds primarily focus on the front line indexes like Nifty, Nifty Next50, SENSEX, etc. which are also bench-marked by large cap mutual funds. Of lately, investors now have wider options to invest in Index Funds that track the Mid Cap Indices and Overseas Indices.
Yearly Performance of Actively Managed Large Cap Funds
Why you should Stop Chasing Best Funds
The above table illustrates heat map of the yearly returns for the most popular large cap mutual funds in India. It is evident that no single mutual fund stays in the top year after year and chasing the best large cap mutual funds or jumping from one best fund to the other could cause you more harm. Let take an example, let’s say you wanted to invest ₹ 1,00,000/- in 2013, you look at the previous year’s returns and select the fund with the best performance, and you would end up investing in Nippon Large Cap Fund.
No Consistency in Performance
But by the end of the year you end up being disappointed, your dream fund which gave the best returns was among the bottom performers. So you jump to the best large cap mutual funds of 2013; which was Axis Blue Chip Fund, in early 2014 and stay invested. If you did that, your returns would have been lower as of end 2019 by ₹ 23,000/- even after out performance for two consecutive years from Axis in 2018 and 2019. Not to mention about the costs incurred in the form of taxes or exit loads. And this happens across different time horizons across different fund types.
Difficult to Predict the next Best Fund
It is important to realize that predicting the best large cap mutual funds is very difficult and one approach to address this has been to acknowledge the increasing preference for Index Funds and allocate monies in them. Index funds invest in the popular benchmarks like Sensex and Nifty and distribute your investments among different companies in the same proportion as in the benchmark.
Index funds eliminate the need to predict the best large cap mutual funds
Index funds eliminate the need to predict the best large cap mutual funds and saves you from incurring transaction costs such as exit loads and taxes when you jump from one fund to the other. Before you get started with investments in these funds, it is necessary to know if equity funds suit your risk appetite. Get in touch with your fee only financial planner and undertake a risk profiler exercise today to know your ideal asset allocation.
What is more important than choosing best mutual funds?
While most people are running after the best performing fund, they fail to do proper due diligence of their personal circumstances. Before you invest in Index Funds you needs to ask the below questions;
What is my financial goal?
It is important to know why you are investing. Most people invest just because some fund is giving the best returns. One needs to identify their goal; what is the time horizon they have? What it the present cost of the goal? How will inflation impact their goals? What is the likely future cost of the goal?
What is the ideal asset allocation?
The ideal asset allocation for an individual depends on factors like the risk profile, investment time horizon and investment preferences. If you goals are within 5 years; equities and equity mutual funds should be avoided as they are very volatile for short term periods. If you have longer periods to stay invested equities may be preferable, but the extent of equity allocation is dependent on your risk profile. Aggressive investors can allocate 80% – 90% of their investments in equity, but for most investors, investing 60% – 70% in equity even for longer periods would be most preferable.
What are the Expected Returns?
People chasing the best returns are fooled by marketing tactics which pick random data points showing phenomenal returns. They fail to understand that the long term performance records of mutual funds show an achievable return of 10% – 12%. For debt instruments it would safe to invest in instruments that deliver returns between 6% – 7%. People chasing superior returns in debt instruments have been punished by the poor quality papers leading to defaults and downgrades.
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