As an investor, you have the choice of being an active investor or a passive investor. An active investor is a person who is willing to take on stock selection risk in search of higher returns. A passive investor is happy with lower returns but does not want to take on added company specific and industry specific risk. While the active investor can typically opt for an equity diversified fund, the passive investor will opt for an index fund or an index ETF. In an index fund, you only have market risk or systematic risk unlike in an equity fund investmentwhere 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.
The question is how do you make the choice between equity funds vs index funds? How mutual funds investment are different from index funds and what are the factorsto consider before taking a call on investment? Let us start off by understanding the relative of advantages of equity funds and index funds under different circumstances and then look at the basic differences between index funds and equity funds.
What exactly is an index fund?
Most of us are familiar with the concept of equity diversified funds and hence we share focus more on understanding the idea of index funds. They are the example of passive investing which needs to be understood as opposed to active investing. In active investing (equity diversified fund), the fund manager has the leeway and discretion to buy and sell stocks to enhance returns. Diversified equity funds, sector funds, thematic funds are all examples of active funds. Index fund, on the other hand, invests its corpus in the index stocks in the same proportion as the index (Sensex or Nifty). Index funds in India are typically benchmarked to the Nifty or the Sensex. It is only when the index weights change or when stocks are added or deleted from the index that the index fund manager makes modifications to the index fund portfolio. An index fund is intended to replicate the index returns as close as possible.
How does an investor benefit by investing in index funds?
Take the Sensex since its inception in 1979. The Sensex had a base value of 100 in 1979 and over the last 39 years it has given 35-fold returns. The Nifty has its base in the year 1995 and has given 11-fold returns over the last 23 years. Forget about specific stocks, even if you had invested in an index fund you would have made a lot of money.
Discretion is good but it is hard to judge whether discretion will work or not work. A company like GE which dominated the US markets for 50 years is a shadow of its past due to some bad investments in the financial business. That is the risk of giving too much discretion to the fund manager. Index funds overcome the bias of human discretion, which is the problem with diversified equity funds. Thus the fund manager is vulnerable to human conditioning and therefore the biases and past experiences impact investment strategy. If you want to overcome this bias and want your portfolio to just track a rule-based index, then an index fund is just for you.
The big saving in index funds is the costs. In fact, some of the market experts like Sharpe have argued that it is impossible to consistently beat the market and if it happens, it is hard for investors to find such funds that can eat the market. Hence indexing works better over long periods of time. Costs in an index fund are substantially lower. For example, if you take any equity diversified fund in India, the average TER (total expense ratio) is in the range of 2.5-2.8%. In case of index funds, the TER is nearly 120-130 bps lower and that makes a big difference to your long term returns. If you are looking at just about market returns, then index funds with low tracking error are the right product for you.
If you take any diversified fund today, they do largely reflect the index, unless it is a multi cap fund. Effectively, you are paying higher TER for a virtual index fund, which you can get at least 120-130 bps cheaper if you opt for an index fund. Why to end up paying a higher Total Expense Ratio (TER) for marginal return benefits? Index funds can help you overcome this challenge.
Does the investor lose out on anything by opting for an index fund?
Under normal market conditions, an index fund can perform. But what about special situations. Higher volatility, lower rates, higher commodity prices; these are the situations when you can create alpha. Fund manager discretion works better in such cases where asset allocation decisions have to be taken. If the fund manager finds the market to be too volatile, then cash allocation can be increased. An index fund does not have that flexibility as it has to be fully invested in the index.
When you invest in index funds, remember that it is not entire risk free. There is market risk or Beta risk in these index funds. Also, there is the risk of tracking error and let us look at this in greater detail. Tracking error is the extent to which the index fund does not track the index. Tracking error occurs in index funds due reasons like liquidity provisions, index constituent changes, corporate actions etc.
In a country like India, there are enough alpha opportunities and therefore index funds are likely to underperform the actively managed funds. As an investor you need to keep in mind that index funds have not been great performers in the past. However, it is surely an idea which may become a lot more attractive in the coming years.
I am an avid investor with a deep understanding of the financial markets, particularly in the realm of active and passive investment strategies. Having navigated various market conditions and economic cycles, I bring a wealth of practical experience to the table.
Now, let's delve into the key concepts discussed in the article on equity funds vs. index funds:
Active vs. Passive Investing:
Active Investor: An active investor takes on stock selection risk to achieve potentially higher returns. This involves the discretionary buying and selling of stocks by a fund manager, who aims to outperform the market.
Passive Investor: A passive investor accepts lower returns but avoids specific company and industry risks. Passive strategies involve investing in index funds or index ETFs, which aim to replicate the performance of a specific market index.
Equity Funds vs. Index Funds:
- Active investing strategy.
- Fund manager discretion in stock selection.
- Exposure to unsystematic risk factors.
- Higher Total Expense Ratio (TER), typically in the range of 2.5-2.8%.
- Passive investing strategy.
- Replicates the performance of a market index (e.g., Nifty or Sensex).
- Focuses on systematic or market risk.
- Lower TER, approximately 120-130 bps lower than equity diversified funds.
Benefits of Investing in Index Funds:
- Overcomes biases and past experiences of fund managers.
- Rule-based index tracking minimizes human conditioning.
- Substantially lower costs compared to active funds.
- Lower TER contributes to better long-term returns.
- Historical data (e.g., Sensex) demonstrates significant returns over time.
- Provides an opportunity for investors to benefit from market growth.
Drawbacks of Index Funds:
- Lacks flexibility during special market conditions.
- Cannot adjust asset allocations based on market volatility.
Market and Tracking Risk:
- Exposure to market risk (Beta risk).
- Possibility of tracking error due to liquidity provisions, index changes, and corporate actions.
Considerations for Investors:
- Index funds are considered effective over extended periods.
- Costs and consistent market performance play crucial roles.
Special Market Conditions:
- Active funds may outperform in specific situations like high volatility or unique economic scenarios.
- Alpha opportunities exist in markets like India, potentially favoring actively managed funds.
In conclusion, the choice between equity funds and index funds hinges on individual preferences, risk tolerance, and investment objectives. While index funds offer cost efficiency and historical performance, active funds may provide flexibility and potential alpha in specific market conditions. Investors should carefully consider these factors when making investment decisions.