Why You Should Not Get Married To the Index Fund Idea.
Mar 29, 2019

Author: Deepika Khude

(Image from Lorenzo cafaro via pixabay)


Extravagant weddings.

Mercury rising.

Failing airline.

Index Funds.

What am I talking about?

I'm talking about the latest trends all around us. Every other person is either playing PUBG, watching Priyanka Chopra-Jonas' wedding pictures, complaining about the rising temperature in Mumbai or giving their management advice to Naresh Goyal on how to revive his failing airline.

And guess what's been giving stiff competition to these newsmakers? The latest 'fad' in the investment world - Index Funds.

You've probably heard compelling arguments about why one should invest in Index funds and how it should form the core of your portfolio. So, it's not surprising that these compelling arguments are the reason why the index funds now account for almost 5% of the industry's total AUM.

[Read: Why Index Funds May Not Be An Ideal Bet For Your Core Portfolio]

Investopedia defines Index Fund as:

An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index(S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. These funds adhere to specific rules or standards (e.g. efficient tax management or reducing tracking errors) that stay in place no matter the state of the markets. 

It is often said that the best things in life are free, but is this 'free' stuff really good for you? To be fair, I'm not arguing that expensive things are better.

My point is that the catalyst of your investment decisions should not be a question of 'cheap or costly'.

The primary argument in favour of index funds is simply that the expense ratio of these funds is relatively low. How many of you (retail investors) look or even care about expense ratios? How many times has the expense ratio of the scheme deterred you from buying that particular fund?

The answer is probably none.

As retail investors, you are not directly affected by expense ratios. Sure, it affects your NAV, but it is not directly billed to you. Let me explain.

Table 1: Actively Managed Equity Fund vs. Index Fund - Who should invest?

Investment in an Actively Managed Equity Fund
(For Aggressive investor)
Investment in an Index Fund
(For Moderately Conservative investor)
Return (over 15 year period) 15% 12%
Expense Ratio 2% 1%
Net Return 15% 12%
(For illustrative purposes only)

I have two friends, Mr A, who is aggressive and Mr B, who is moderately conservative. Mr A invests in a diversified large-cap equity fund and earns 15%. Assuming the expense ratio of the fund is 2%, ideally, he has made a net return of 15% as the return is after adjusting for the 2% expense ratio.

Mr B, on the other hand, invests in an Index fund and earns 12%, after accounting for the 1% expense ratio.

Both Mr A and B are happy and content. Whose approach would you say is correct?

The argument is fairly simple. Are you willing to pay an additional 1-1.5% to book an additional gain of 2-4%?

Let's take a real example. ICICI Prudential Bluechip Fund is a top rated large-cap fund recommended by PersonalFN and has provided a return of 18.44% in the last 10 years (data as on March 27, 2019). The fund has NIFTY 100 TRI as its benchmark, which has returned 16.30% in the same period.

Table 2: How ICICI Prudential Bluechip Fund has performed vis-a-vis its benchmark across time frames

Scheme Name 3 years (%) 5 years (%) 10 years (%) Expense Ratio (%)
ICICI Prudential Bluechip Fund 15.01 14.24 18.41 1.26%
Nifty Index Funds 15.63 13.47 16.30 0.85%
Data as on March 27, 2019)
(Source: ACE MF)

Assuming I had invested Rs 5,000 in a Systematic Investment Plan (SIPs) each in Index Fund and ICICI Prudential Bluechip Fund, in 10 years the difference in returns would be Rs 2.15 Lakhs.

Table 3: SIP returns of ICICI Prudential Bluechip Fund vis-a-vis its benchmark over 10 years

Particulars ICICI Prudential Bluechip Fund Index Fund
Monthly Investment Rs 5000 Rs 5000
Tenure of Investment 120 months 120 months
Rate of Return 18.41% 16.30%
Future Value Rs 17,25,808 Rs 15,10,370
(Data as on March 27, 2019)
(Source: ACE MF)

So, as I asked you earlier, is something that is available at a lower cost good for your portfolio?

There is no right answer.

Like my friends, Mr A and Mr B, it is completely dependent on your risk profile. If you want to gain 2-4% additional return, taking additional risks is necessary. However, taking a calculated risk by choosing the best mutual funds is necessary if you wish to clock an alpha or fetch additional returns.

This is the reason why actively managed funds charge a higher expense ratio. Of course, this can be mitigated by shifting to direct plans of the actively managed funds. This way, you get the management expertise at a lower cost.

[Read: Best SIPs To Invest in 2019]

So, why is there so much brouhaha around Index Funds?

Why do they seem like an oasis in the volatile equity market desert?

Simply because as a layman when you look at the market, you look at Sensex and Nifty, which
encompasses only select 30 & 50 stocks respectively.

Any increase in Sensex and Nifty is due to an increase in the valuation of certain stocks in the market. The recent rally is because of the great appreciation in value of certain heavyweights of the index.

Your next question might be, does PersonalFN strictly say no to Index Funds?

At PersonalFN, we are of the view that Index Funds can form up to 10% to 20 % of your entire equity portfolio. But don't get married to the idea that only index funds are the best to invest in mutual funds. If you sensibly invest in the best actively managed mutual fund schemes, your portfolio can outperform the benchmark indices. Of course, this is assuming you want and have the appetite for the upside and downside of a 2-4% return.

Want to learn how to select winning mutual funds? Download PersonalFN's 10 Steps to Select Winning Mutual Funds

Hence, it's always better to structure your portfolio in accordance with the asset allocation strategy best suited for you and align it to your financial goals. At PersonalFN, we believe that a core and satellite approach to your investments is the ideal way to navigate the volatility of equity markets.

Editor's note: We have a ready solution that could be suitable for you -- PersonalFN's Premium Report, "The Strategic Funds Portfolio For 2025(2019 Edition)".

In the 2019 Edition of PersonalFN's Premium Report, "The Strategic Funds Portfolio For 2025", you will get access to a ready-made portfolio of its top recommended equity mutual funds for 2025 that have the ability to generate lucrative returns over the next 5 to 6 years. Subscribe now!

Add Comments

Apr 01, 2019

I think the recent noise about Index funds is due to the increasing awareness that in developed markets the Index fund performance has been much better than those of actively manged funds. However in the Indian markets, this is not true , at least going by the record till date. Having said that, it would've been interesting if the author had compared the performance of an Index fund tracking the Nifty next 50 Index , instead of the Sensex, such as ICICI Pru Next50 index fund.

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