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Should you invest in an index fund or mutual fund?

The answer: Depends

What is an index fund?

An index fund is a portfolio of stocks that mimics the composition and performance of a financial market index (like Nifty 50 and Sensex). It is a passively managed fund, as opposed to mutual funds which are actively managed by a fund manager.

Advantages of index funds

Index funds boast of three clear advantages over actively managed funds. As index funds replicate the underlying index, there is no uncertainty of underperformance. Second, actively managed funds with expense ratios of over 1.5 % can take a chunk out of the final returns. Index funds, with an expense ratio of less than 0.25 per cent, are a lower cost alternative. Third, if the fund manager of an active fund quits, the future performance of the fund becomes uncertain. No such issues exist with an index fund.

Not all index funds have competitive total expense ratios. Funds for indices like the Nifty Next 50 can be close to 1%. Furthermore, the tracking error (Tracking error is the difference between a portfolio's returns and the benchmark or index it was meant to replicate) in index funds can further add to the cost of the fund.

Risks with index funds

While index funds have certain advantages, there are certain implicit risks that are natural when investing in the equity markets. First, if stock prices are volatile, even the index fund will mirror the ups and downs of the market. Second, index funds in India (such as Nifty 50) often carry concentration risks because of their high weights in top sectors and companies. It is quite possible for companies with chequered balance sheets or questionable managements to end up in these indices.

Performance of Active Funds and Index Funds in Largecap, Midcap and Smallcap Categories

Largecap Funds

According to analysis, only about 25% of the actively managed large cap funds have managed to beat the index (largely Nifty 50) over 3 years. Hence many wealth advisors conclude that in this category, index funds are superior. However there are 2 caveats to this analysis. First, given the stress in liquidity and the volatility in India’s public markets over the last 1.5 years, it is natural for funds to have underperformed the index. If prospects of the economy improve, the results would look very different.

Midcap Funds

The 3-year returns in this category beat the benchmark comfortably. As actively managed midcap funds can have some exposure to large caps (an index such as the Nifty 100 only has purely midcaps), their ability to contain downside is much higher.

Small Cap Funds

In this category the jury is clear; there is no replacement for active funds. Small funds have actively beaten the index (such as the Nifty Smallcap 100). There is significant scope for alpha in this category. Furthermore, you need a nimble footed fund manager to actively track the small caps and take the appropriate decisions as a small change can hamper the prospects of individual companies.

In Conclusion:

For wealth creation over the long term, the choice of funds would depend on the goals and choices of the individual investor. If you a prefer a safe, low cost, no-frills approach, then index funds are the way to go. However, if you are looking to juice up your returns and achieve your goals more quickly, then investing in active funds is the answer. Furthermore, the allocation to large cap, midcap and small cap funds would depend your aggression and risk appetite.

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