Should you consider investing in index funds?

Recently, it has been reported in some of the media houses that the mutual fund industry has approached the regulator to come out with a new benchmark for large-cap dedicated funds. The reason that was attributed to the creation of such a new benchmark was the underperformance of most of the large-cap dedicated funds in comparison to their benchmark and especially those, which are benchmarked against Nifty or Sensex, were finding hard to beat them. This was because the best performing stock of the index i.e. Reliance Industries is now almost 15 per cent of Nifty and mutual fund schemes cannot hold more than 10 per cent of an individual stock in their portfolio. Therefore, these funds cannot participate in the growth of the company. Hence, this is the reason why mutual fund schemes are underperforming. Later on, the industry body refuted media reports and said that there was no such idea discussed with the regulator.

Nonetheless, this remains a problem for most of the funds that may impact their short-term performance. And ultimately, it impacts the investors too. So, is it the right time to invest in index funds, which replicate and track indices and hence investing in securities in the same proportion as found in the benchmark index? This will help them to benefit most out of any company giving outsized returns. These index funds are very popular in the developed markets; however, these are yet to capture the imagination of the Indian investors.

There are different reasons why index funds are gaining traction. Apart from the larger interest by the institutional investors, one of the basic reasons why passive investments are gaining popularity is their low cost. If we check the expense ratio of open-ended equity funds at the end of September 2020, index funds were far cheaper than actively managed funds. For example, a regular MF scheme has an expense ratio of more than or around two per cent compared to index funds that have an expense ratio of 0.74 per cent.  

Index funds are cheaper and cost one-third of the cost of other actively managed regular funds. Although the difference looks quite low (around 1.5 per cent), in the long run; it has a huge impact on returns. For example, this meagre difference will compound to about 6 per cent in 3 years, 13.5 per cent in 5 years, and almost 56 per cent over the span of 10 years.

Should you go for index funds?

A deeper analysis of the index funds and the respective actively managed fund shows that any single large-cap funds fail to beat their benchmark indices consistently. There may be some funds that might outperform the index; however, it has been a bit difficult to maintain their performance on a consistent basis. Therefore, a long-term investor should include large-cap dedicated index funds instead of an actively managed fund in his portfolio.