Index funds – Navigating the index fund space (2022)

Index funds have gained much in popularity in recent years. From under Rs. 8,000 crores of assets two years ago, they now manage close to Rs. 50,000 crores, and counting.

The buoyant stock market, combined with investor dissatisfaction with the underperformance of actively managed large cap funds has steered investor money into cost-effective index funds.

An index fund invests in the constituents of a particular index – equity or debt – with the aim of mimicking its returns. This is done at a lower cost than an active fund, which aims to outperform an index.

Today, there are over 50 equity index funds tracking diverse indices – ranging from large cap and small cap to momentum and quality. Are index funds worth investing in? Here are some insights to help you decide.

Large cap index funds

Large cap index funds are appealing because the vast majority of active large cap funds fail to outperform their benchmark index. This has been particularly so after SEBI’s 2018 recategorization exercise. Today, there is a wide range of large cap index funds from which to pick.

Investors can choose from four options – index funds tracking the Nifty 50 TRI, the Nifty Next 50 TRI, the Nifty 100 TRI, and the S&P BSE Sensex TRI.

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Nifty and Sensex: The Nifty 50 TRI and the Sensex TRI, which represent the top large cap companies listed on the NSE and the BSE, respectively, have on average, delivered roughly similar returns across different investment periods over the last 10 years (see first table). The percentage of negative returns have been equally similar. So you can pick an index fund tracking either of these two indices for large cap exposure in your portfolio.

Go for an index with a relatively lower expense ratio. Another important indicator is the tracking error (TE), which provides an indication of how closely an index fund is tracking its index. The lower the TE, the better it is. However, given that the TEs for most large cap index funds fall within a narrow range of 0.10 – 0.27 per cent, it is hardly the differentiating factor here. Large caps represent the most liquid segment of the stock market, making it easier for funds to closely replicate the index with minimal impact cost.

The IDFC Nifty Fund and the ICICI Pru Nifty Index Fund, with expense ratios of 0.08 per cent and 0.17 per cent respectively under their direct plans are good picks. Two other options are the ICICI Pru Sensex Index Fund and the Nippon India Index Fund – Sensex Plan that charge expense ratios of 0.16 per cent and 0.15 per cent, respectively. All these funds have TEs of under 0.16 per cent and a long track record. Only funds with at least 3 years’ history have been considered for our analysis.

Nifty 100: While the Nifty 100 TRI represents a good investment, index funds tracking this large cap index have only recently been launched by AMCs such as Axis MF and IDFC MF – so they don’t have much of a performance record for investors to consider.

The Nifty 100 comprises the largest 100 companies (large caps) and is well-diversified across sectors. It accounts for 70 per cent of NSE’s total market capitalization. The returns from this index are not very different from those of the Nifty 50 and the Sensex (see first table).

In the absence of a track record, investors can wait to invest in a Nifty 100 TRI index fund. But, as the index comprises the most liquid listed stocks, a passive fund linked to this index should be able to deliver returns matching those of the index.

Nifty Next 50: The Nifty Next 50 consists of the 51 st to 100 th largest companies and represents 14 per cent of the NSE’s total market cap. While it comprises large cap stocks, its volatile nature means that the index cannot serve the role of a relatively stable large cap portion in your portfolio. Data shows that the superior returns of the Nifty Next 50 compared to say, the Nifty 50 or the Nifty 100 have been accompanied by higher volatility (see first table). This makes the index suitable only for long-term high-risk investors who want to boost their overall returns.

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The Nifty Next 50 index funds from ICICI Prudential MF and UTI MF, are good options. Their TE of around 0.14 per cent is a tad lower than that of the other Nifty Next 50 index funds considered. The two funds charge expense ratios of 0.30 per cent and 0.33 per cent, respectively, under their direct plans.

Its’ worth noting that, while it may seem obvious to invest in a Nifty 100 index fund instead of making a 50:50 investment in a Nifty 50 and a Nifty Next 50 index fund, it may not lead to the same result. The Nifty 100 contains the Nifty 50 and the Nifty Next 50 companies put together, but their weights in the combined index are very different. The Nifty 100 is a market cap weighted index – this means that the significantly larger Nifty 50 companies get a higher total weight in the index making it overwhelmingly like the Nifty 50 itself. A Nifty 100 index fund will, therefore, work as a more diversified substitute for a Nifty 50 index fund.

Index funds – Navigating the index fund space (1)

Mid and Small cap index funds

High risk investors interested in passive exposure to midcaps have four index funds, all of which track the Nifty Midcap 150 TRI, to choose from. With all active midcap funds, except the Axis Midcap Fund, failing to outperform the Nifty Midcap 150 TRI – based on 3-year and 5-year rolling returns in the last 7 years, along with having higher instances of negative returns than the index, the case for midcap index funds is strong (see second table). However, none of the existing midcap index funds have a long performance record – three were launched in 2021 while the oldest, from Motilal Oswal MF, was launched in September 2019. Investors therefore need to wait and watch.

Similarly, small cap index funds too, have only a limited history. The oldest, from the Motilal Oswal MF stable, was launched only in September 2019. All three of the available funds track the Nifty Smallcap 250 TRI. With many small cap stocks facing liquidity issues, taking positions in these stocks to consistently mirror the small cap index composition may not be easy. More to the point, even assuming the funds match the index returns, the Nifty Smallcap 250 Index may not be the best way to get small cap exposure.

Many actively managed small cap funds are doing a good job of navigating the small cap space – with higher returns and relatively less volatility (see second table). Investors with a high-risk appetite are better off going active rather than passive here. Small cap funds from SBI MF, Axis MF, and Nippon India MF are the top performers.

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Index funds – Navigating the index fund space (2)

Strategy index funds

Strategy indices use a strategy or a factor such as momentum, quality or low volatility, by applying quantitative parameters to a broader index. Take for example, the Nifty200 Momentum 30 Index which tracks the performance of the top 30 companies in the Nifty 200 based on their normalised momentum score. Or the Nifty 100 Low Volatility 30 Index that tracks the performance of 30 stocks in the Nifty 100 with the lowest volatility in the past year.

Likewise, the equal-weight versions of the Nifty 50 and the Nifty 100 indices provide an alternative weighting strategy, that is, of assigning equal weighs, instead of the market capitalization-based weighting of these indices. The equal weight indices have a less concentrated sector exposure than the market cap weighted indices.

Investors can use some of these indices to get exposure to specific factors, in addition to their core allocation to large cap indices.

Nifty200 Momentum 30 Index:

A momentum strategy relies on stocks that have done well in the recent past to continue outperforming and vice versa. Such a strategy assigns higher weights to outperforming stocks and sectors, and vice versa. The Nifty 200 Momentum 30 Index selects the top 30 high momentum large and mid-cap stocks from the Nifty 200 based on their last 6-month and 12-month price return after adjusting for daily volatility. Each stock is weighted based on its free float market cap multiplied by its momentum score subject to a 5 per cent cap.

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Data shows that the Nifty 200 Momentum 30 Index has delivered 3-year and 5-year rolling returns (CAGR) of 16 per cent and 17 per cent, outperforming its parent index returns of 10 per cent and 11 per cent, respectively, over the last 7 years.

Two AMCs, UTI MF and Motilal Oswal MF, offer index funds based on this index. Thesewere launched in March 2021 and January 2022, respectively. While it’s still too soon to assess their performance, high-risk investors can keep this index on their radar for future – for a small exposure in their overall equity portfolio.

Nifty100 Quality 30 Index:

The Nifty100 Quality 30 Index comprises the top 30 companies selected from the parent index based on their quality scores. ‘Quality’ companies are defined as those with high profitability (return on equity), low leverage (debt to equity ratio), and low earnings volatility. The stocks are weighted based on their quality score and their free float market cap, subject to a 5 per cent cap.

The Nifty100 Quality 30 tends to lag the Nifty 100 on returns – 3-5-year rolling returns (CAGR) of 8-8.4 per cent versus 10-11 per cent. Its USP lies inits ability to provide good downside protection, that is, falls less in periods of uncertainty and weak economic growth. Over the last seven years, the quality index has captured only 86 per cent of the downside of its parent index.

Only one AMC, Edelweiss MF, offers a Nifty 100 Quality 30 Index fund (earlier an ETF). The fund is less than six months old and charges an expense ratio of 0.27 per cent under the direct plan. The index itself has been in existence since March 2015.

Nifty equal weight indices: Unlike the momentum and quality indices that have outperformed their respective parent indices, to a large extent, the Nifty 50 and the Nifty 100 Equal Weightindices do not show a consistent trend of outperformance.

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The market cap (MC) and equal weight (EW) indices go through alternating periods of out / under performance. Typically, EW indices fare well during periods of broader market rallies and underperform when there is polarization, as was seen over the last few years when a handful of stocks drove the bulk of index returns. While mean reversion – return to more dispersed returns from the earlier polarized returns – would dictate outperformance by EW indices going forward, their mixed performance record does not provide a strong case for investing in them.

To understand the low volatility strategy and funds based on the same, read here.

Index funds – Navigating the index fund space (3) COMMENT NOW

FAQs

Is index fund a good strategy? ›

Index funds are a great investment for building wealth over the long-term, which is why they are popular with retirement investors.

How much of your portfolio should be in index funds? ›

What Is the 90/10 Rule in Investing? The 90/10 rule in investing is a comment made by Warren Buffett regarding asset allocation. The rule stipulates investing 90% of one's investment capital towards low-cost stock-based index funds and the remainder 10% to short-term government bonds.

Can you beat the market with index funds? ›

The Barriers

Look for index funds with ultra-low fees of 0.05% to 0.2% a year, and you'll get close to equaling the market, though you won't beat it.

What are index funds examples? ›

An “index fund” is a type of mutual fund or exchange-traded fund that seeks to track the returns of a market index. The S&P 500 Index, the Russell 2000 Index, and the Wilshire 5000 Total Market Index are just a few examples of market indexes that index funds may seek to track.

Why are index funds so successful? ›

One major reason is that they generally have much lower management fees than other funds because they are passively managed. Instead of having a manager actively trading, and a research team analyzing securities and making recommendations, the index fund's portfolio just duplicates that of its designated index.

What is better than an index fund? ›

ETFs can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange. In addition, investors can also buy ETFs in smaller sizes and with fewer hurdles than mutual funds.

What is the 5 percent rule in investing? ›

Key Takeaways. The five percent rule, aka the 5% markup policy, is FINRA guidance that suggests brokers should not charge commissions on transactions that exceed 5%.

How much should I have in index funds to retire? ›

To produce that level of income in retirement, many people will need over $1 million in retirement savings and investments to live the way they want. But $1 million is a good starting baseline.

How many index funds do you need for a diversified portfolio? ›

Experts agree that for most personal investors, a portfolio comprising 5 to 10 ETFs is perfect in terms of diversification. But the number of ETFs is not what you should be looking at. Rather, you should consider the number of different sources of risk you are getting with those ETFs.

What are 2 cons to investing in index funds? ›

The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).

Can index funds ever crash? ›

That means it includes the same stocks as the index, which are stocks from 500 of the largest, strongest companies in the U.S. In the short term, it's possible that your investments could take a hit if stock prices fall. No investment is immune to volatility, and S&P 500 index funds are no exception.

Can you get rich off index funds? ›

Index funds are an easy way to grow wealth, and it pays to focus on S&P 500 funds in particular. Doing so could be your ticket to attaining millionaire status in your lifetime.

How do you make money from index funds? ›

How Do Index Funds Make Money? Index funds make money by earning a return. They're designed to match the returns of their underlying stock market index, which is diversified enough to avoid major losses and perform well.

How exactly do index funds work? ›

Index funds are investment funds that follow a benchmark index, such as the S&P 500 or the Nasdaq 100. When you put money in an index fund, that cash is then used to invest in all the companies that make up the particular index, which gives you a more diverse portfolio than if you were buying individual stocks.

What is the most popular index fund? ›

An S&P 500 index fund invests in each of the 500 companies in the S&P 500 (SNPINDEX: ^GSPC). It doesn't try to outperform the index; instead, it uses the index as its benchmark and aims to replicate its performance as closely as possible. S&P 500 funds are by far the most popular type of index fund.

Why are index funds the best investment? ›

Index funds mirror the performance of an existing collection of stocks, such as the S&P 500 index. Index funds are a passive investment, meaning they aren't managed by a professional. Index funds often perform better than active funds over the long-term, and they're cheaper. Index funds can help minimize risk.

Why you should just invest in index funds? ›

Investing in index funds has long been considered one of the smartest investment moves you can make. Index funds are affordable, enable diversification, and tend to generate attractive returns over time. Historically, index funds outperform other types of funds that are actively managed by top investment firms.

Why do index funds always go up? ›

Most index funds represent at least a portion or sector of the overall market. The overall market is almost certain to produce tangible value over the long term. Therefore, total book value of all the underlying stocks in an index is expected to go up over the long term.

What is the most reliable index fund? ›

Best index funds to invest in for November 2022
  • Fidelity ZERO Large Cap Index.
  • Vanguard S&P 500 ETF.
  • SPDR S&P 500 ETF Trust.
  • iShares Core S&P 500 ETF.
  • Schwab S&P 500 Index Fund.
  • Shelton NASDAQ-100 Index Direct.
  • Invesco QQQ Trust ETF.
  • Vanguard Russell 2000 ETF.
15 Nov 2022

Is it better to invest in index funds or stocks? ›

The biggest difference between investing in index funds and investing in stocks is risk. Individual stocks tend to be far more volatile than fund-based products, including index funds. This can mean a bigger chance for upside … but it also means considerably greater chance of loss.

Which is better equity or index fund? ›

In an index fund, you only have market risk or systematic risk unlike in an equity fund investment where you also have the unsystematic risk factors impacting your fund returns. However, the assumption in active investing is that the stock selection will result in higher returns.

What is the 7% rule for investing? ›

Let's say you have an investment balance of $100,000, and you want to know how long it will take to get it to $200,000 without adding any more funds. With an estimated annual return of 7%, you'd divide 72 by 7 to see that your investment will double every 10.29 years.

What is the 80% rule in trading? ›

In investing, the 80-20 rule generally holds that 20% of the holdings in a portfolio are responsible for 80% of the portfolio's growth. On the flip side, 20% of a portfolio's holdings could be responsible for 80% of its losses.

What is the 2% trading rule? ›

One popular method is the 2% Rule, which means you never put more than 2% of your account equity at risk (Table 1). For example, if you are trading a $50,000 account, and you choose a risk management stop loss of 2%, you could risk up to $1,000 on any given trade.

Can you retire a millionaire with index funds? ›

Broadly diversified index funds can be your investment vehicle for a ride to becoming a millionaire retiree, if the stock market performs as it has in the past.

How long should you stay in an index fund? ›

Index Funds Work Well As Short-Term Investments

In general, some advisors suggest that index funds ought to be held for at least five years, if not 10 or more.

What percentage of retirees have a million dollars? ›

In fact, statistically, around 10% of retirees have $1 million or more in savings. The majority of retirees, however, have far less saved. If you're looking to be in the minority but aren't sure how to get started on that savings goal, consider working with a financial advisor.

Is an S&P 500 index fund enough diversification? ›

It's also worth noting that an S&P 500 index fund is fairly diversified. Its investments are spread out among 11 major industries, and no sector has more than 30% of the money invested. Here's a look at the different business sectors that make up the index.

How many index funds should I have in my 401k? ›

For many retirement investors, a three-fund portfolio is sufficient. If you're feeling like a minimalist, you can get the job done with two funds—or, if you're feeling very Marie Kondo, even just one single, solitary fund.

How many funds should you have in your portfolio? ›

So, what's the magic number? There isn't a strict rule, but between five and 10 funds is usually a good idea. That lets you allocate money to different types of funds and markets without doubling up too much. It's also a manageable number to monitor and won't cost you too much in trading fees.

What does Warren Buffett think about index funds? ›

Warren Buffett likes index funds — especially those that follow the S&P 500. “In my view, for most people, the best thing is to do is owning the S&P 500 index fund,” he once said.

What happens if everyone invested in index funds? ›

For example, if everyone buys index funds, the values of the stock prices of the underlying companies won't reflect the fair value of the companies in the stock market. Instead the prices of stocks will simply reflect the the inflow of funds to indexes.

What is the main disadvantage of index fund? ›

Disadvantages of Index Funds

There are also disadvantages to using index funds for investments. The lack of flexibility limits index funds to well-established investment styles and sectors. Furthermore, stock indexes experienced a great deal of volatility in 2020.

Do rich people invest in index funds? ›

Stocks and Stock Funds

Some millionaires are all about simplicity. They invest in index funds and dividend-paying stocks. They like the passive income from equity securities just like they like the passive rental income that real estate provides.

What is the average portfolio loss in 2022? ›

From the start of 2022 through September 28, a 60/40 portfolio invested in line with benchmark U.S. stock and bond indexes shed 20%. Only two calendar years — both during the Great Depression — have been worse. Factor in rising prices, and things get even darker.

Why do index funds lose money? ›

You can lose money if investments in the index lose value. Since many of those indices are financial markets, you should expect them to go down from time to time.

Can I sell my index funds anytime? ›

Each investor owns shares of the fund and can buy or sell these shares at any time. Mutual funds are typically more diversified, low-cost, and convenient than investing in individual securities, and they're professionally managed.

Can the S&P 500 make me rich? ›

With enough time and sufficient money invested, becoming a millionaire is very achievable. The S&P 500 has averaged annual growth of close to 10% over long periods. That kind of return is good enough to build solid wealth.

Should a beginner invest in index funds? ›

Index funds are a type of mutual fund or exchange-traded fund (ETF) that hold stocks or bonds to replicate a particular index. They can be a great investment for beginners, but it's important to understand how to pick the right fund, as well as the pros and cons.

How much should you put in an index fund each month? ›

Most financial planners advise saving between 10% and 15% of your annual income. A savings goal of $500 amount a month amounts to 12% of your income, which is considered an appropriate amount for your income level.

How many index funds should I have in my portfolio? ›

Ideally, 6 to 8 funds are good enough to build your MF portfolio. As the size of the portfolio increases, you may invest in a maximum of 10 funds to reduce the risk of being overdependent on any particular fund or fund house. However, the funds you are investing in are across equity, debt and hybrid categories.

Why index funds are better than mutual funds? ›

Index funds seek market-average returns, while active mutual funds try to outperform the market. Active mutual funds typically have higher fees than index funds. Index fund performance is relatively predictable over time; active mutual fund performance tends to be much less predictable.

What are the Big 3 index funds? ›

This burgeoning passive index fund industry is dominated by BlackRock, Vanguard, and State Street, which we call the 'Big Three'.

Which index fund is best in 2022? ›

Best Index Funds to Invest in October (2022)
  • IDFC Nifty 50 Index Fund. ...
  • Tata S&P BSE Sensex Index Fund. ...
  • ICICI Prudential Nifty Direct Plan-Growth. ...
  • HDFC Nifty 50 Plan Direct-Growth. ...
  • SBI Nifty Index Direct Plan-Growth. ...
  • Aditya Birla Sun Life Nifty 50 Direct-Growth. ...
  • Axis Nifty 100 Index Fund Direct-Growth. ...
  • Tata Index Nifty Direct.

Why you should only invest in index funds? ›

Index funds mirror the performance of an existing collection of stocks, such as the S&P 500 index. Index funds are a passive investment, meaning they aren't managed by a professional. Index funds often perform better than active funds over the long-term, and they're cheaper. Index funds can help minimize risk.

How do you benefit from index funds? ›

Built-in benefits of index funds
  1. Lower risk through broader diversification. Each index fund contains a preselected collection of hundreds or thousands of stocks, bonds, or sometimes both. ...
  2. Lower taxes. Index funds don't change their stock or bond holdings as often as actively managed funds. ...
  3. Lower costs.

Do rich people use index funds? ›

Yet, despite Buffett's advice, the wealthy typically don't invest in simple, low fee, market-matching index funds. Instead, they invest in individual businesses, art, real estate, hedge funds, and other types of investments with high entrance costs.

What is Warren Buffett's favorite index fund? ›

Buffett, who chose the Vanguard Index Fund as a proxy for the S&P 500, won by a landslide. The five fund of funds had an average return of only 36.3% net of fees over that ten-year period, while the S&P index fund had a return of 125.8%.

Should I put my savings in an index fund? ›

Instead, you should choose index funds every time, because that way you'll have “diversified away all risks of owning individual stocks, and then guaranteed yourself your fair share of growth of the entire stock market. That's why I buy index funds.”

Is an index fund enough for retirement? ›

For total-return-oriented retirees who are using rebalancing (trimming appreciated securities) to meet living expenses, index funds and ETFs also work well. That's because index funds and ETFs are typically pure plays on a given asset class.

How much should I put in index fund monthly? ›

Most financial planners advise saving between 10% and 15% of your annual income. A savings goal of $500 amount a month amounts to 12% of your income, which is considered an appropriate amount for your income level.

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