What are Index Funds? Cons of index funds

We sometimes mimic the best strategies or life plans of our role models. Similarly, the index funds track or mimic the market indices such as Nifty 50, Sensex, etc.

These funds use a passive investment strategy, where the responsibility of the fund manager is to only mimic the composition of the Index.

This is the opposite of the active investment strategy used by mutual funds which promise to beat the benchmark or market returns, where the fund manager carefully analyses the market for opportunities and picks the perfect stocks for the portfolio by constantly buying and selling stocks and other assets to deliver the best return. 

Whereas, the Index fund merely mirrors the companies or securities present in a particular index. For example, if ABC stock makes up 5% of the value of the Index, then the fund manager of XYZ fund with a Net Asset Value (NAV) of 10,000 will allocate 5% which is 500 to buy ABC stock.

The idea of this investment strategy is “If you can’t beat them, then join them” – where one receives the average market return. Hence the responsibility of the manager is limited to only following the composition of the index and including the same in the fund, with an objective to deliver similar returns (with the same risk exposure) as the index.

Index funds deliver a return smaller than the benchmark that they are tracking. Since there is no such thing as a free lunch, this is the expense ratio which is the fees charged by the fund to manage your money.

An Index fund tracking Sensex (India’s benchmark stock index. Its composition is 30 of the largest and large-cap stocks), would invest in the same 30 stocks in the same proportion.

Index funds can track different assets such as – stocks, bonds, commodities (Such as Oil, Gold, etc.), and currencies. 

Cons of Index funds

1. Vulnerability to market crashes and market risks

These funds are exposed to the same risk as that of the indices that they mimic. For example, if the Sensex comes down in value (similar to the crash of the Sensex in March 2020, where it fell by 23%), the funds tracking this index would follow the decline and have wealth destruction or decrease in NAV.

Index funds which track bonds (This financial instrument are similar to the loan. Here, the investor is the lender, and the party which issues the bond is the borrower.

The lender/investor receives a periodic interest payment – also known as a coupon. However, the bonds are tradable on stock exchanges), are prone to changes in interest rates.

When the interest rates in the market decrease (regulated by RBI), the demand for bonds increases, and hence the price of the bonds increases.

This leads to an increase in the NAV or the Index funds which track these bonds. Whereas, when the interest rates increase, the bonds decline in value and hence put these funds in the danger zone.

2. Less Flexibility & Limited Gains

The fund cannot invest in a sector that is performing extremely well if it is not a part of the Index that it tracks. Hence, the gains that could be earned in case of a sector boom become limited.

The investor only earns the returns of the market, whereas an investor in an actively managed fund could earn higher.

Why should you consider investing in Index Funds?

1. Lower Expense Ratio? Lower cost (Paisa Vasool)

As mentioned earlier, due to the passive investment strategy, the expense ratio or the fee charged to the investor is lesser when compared to actively managed funds which frequently buy and sell. charge higher for these transactions and services provided.

This could drag down the growth of the portfolio over a longer period of time. This is illustrated by an example as shown below.

If an investor had invested Rs.50,000 in 1991 (30 years ago) in Index fund A, he would have received a return of 11.7% and his investment would amount to 12.2 lakhs. Whereas, in Fund B it would amount to 10.1 lakhs (as shown in the figure).

This difference of 2.1 lakhs is due to the lower expense ratio of the Index fund. Hence, in the longer term, these funds perform better than the actively managed funds offering similar returns.

It is important to check the benchmark of an actively managed fund and decide if it is doing justice for the higher expense ratio that is being charged. Hence by surrendering to war with the market, you actually win.     

2. Diversification: Ensuring that you don’t put all your eggs in one basket

These funds are an indirect instrument of buying into the entire market, which implies that as an investor you are exposed to the entire market and its risks.

If a sector such as Pharma was in the boom during March 2020, but the Financial sector stocks saw a decline – the stocks that are appreciating make up for the ones that are declining to keep the returns constant or increasing – implies a diversified portfolio. 

Conclusion

When you are choosing an Index fund, aim to invest in a fund that tracks a large portion of the market hence giving a wider range of a diversified portfolio.

Also, chose a fund with low tracking error – which is the difference between the Index returns and the funds’ returns. Hence a fund with a low tracking error indicates that it mirrors or tracks the index closely.

Another aspect to consider while choosing the fund is the cost of the fund and past performance.