Are Index Funds A Good Fit in your Mutual Fund Portfolio?

By Adhil Shetty | December 27, 2017

Index Mutual Funds invest in a broad market index, provide low operating expenses and low portfolio turnover. Read on to know more about its features.

In the quest for Mutual Funds to further diversify your portfolio, you would have come across the concept of index funds at one time or another. These refer to funds that invest in a broad market index – such as the Sensex or the Nifty – with all the stocks in these indices being represented in the portfolio in their respective weights.

This theoretically ensures a performance identical to that of the index which is being tracked. Features of index funds also include the following points.

Low Expense Ratio

Index funds by their very nature are passive instruments, charging lower fees than their actively managed counterparts. Often, you have index funds that carry an expense ratio of ~1%, while an actively managed diversified equity fund will typically have an expense ratio north of such a figure.

While they certainly shade most equity funds in this context, it is worth noting that management fees of 1% is still quite high for a passive product, especially considering that there is no explicit requirement of active stock selection or rapid calls on a day-to-day basis.

Tracking Error

Even though the mandate of an index fund is to tightly align with its index, most index funds in the market today have tended to stray a little over time. This is a phenomenon known as tracking error, and it is a metric that quantifies the extent to which an index fund deviates from the benchmark index over any given period of time.

The lower the tracking error, the better the index fund in question will keep pace with its index.

Performance:

In the Indian context, index funds have been a low-risk, low-return proposition compared to their equity brethren. While their lower expense ratios give them an advantage, they have not caught on in the Indian scene as much as in certain developed markets. This is because diversified equity funds with a fund manager at the helm have largely managed to surpass the index over a good period of time.

On the other hand, investments in index funds should not be expected to beat the markets. Until they can prove to be a more attractive option, be it through a yet lower expense ratio or a greater variety of trackable indices, you are better advised to stick to actively managed equity funds for wealth creation over the long term.

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About Adhil Shetty

Adhil Shetty is the Founder and serves as the Chief Executive Officer of BankBazaar.com. Adhil has a Master’s degree in International Relations with a specialization in International Finance and Business from Columbia University in the City of New York, and a Bachelor’s degree in Engineering from the College of Engineering Guindy, Anna University. Adhil is an expert in Personal Finance (Car loan/Home loan and personal loan) and he majorly consults on investment and spends rationalization for the Indian loan borrowers. His guidance is number based with real time interest rate calculations and hence useful for consumer’s real time query.

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