With large-cap funds struggling to beat their benchmark performance, many are mulling about shifting to index mutual funds.
Over the past couple of months, the Indian markets have been quite volatile. Large-cap funds are appearing to have a hard time beating benchmarks, in part due to increased costs. This has pushed many toward opting for passive investing. In addition to this, the recent re-categorization of mutual funds schemes has led a number of investors to reportedly consider switching to passively-managed index funds. This article sheds light on whether investors should make such a move, taking into account the current market scenario. But first, let us understand what index funds mean.
What are Index Funds?
Index funds are a type of mutual fund that imitates the portfolio of a financial market index. They passively track a particular index’s performance and are very low on cost. Exchange Traded Funds (ETFs) are a kind of passive fund.
When an individual buys a share of an index fund, he or she is purchasing the share of a portfolio which has an underlying index’s securities. The two popular indices in the country include - BSE Sensex and NSE Nifty.
Should I Switch to Index Mutual Funds?
In case of an active fund, the fund manager – via active stock picking - strives to earn extra returns over the benchmark index. However, numerous studies conducted abroad have shown that it becomes difficult to beat the benchmark index with each passing year. That is why many believe it would be a better call to park money in a low-cost index fund that mimics the broader market.
If one is looking to have a large-cap exposure, then passive investing can be a wise decision. In case the investor prefers equities, a passive broad market strategy (via an index ETF) can seem fitting. Some experts have already begun suggesting passive funds for a large-cap allocation and having active funds in case of small and mid-cap allocation in portfolios.
One should be careful not to compare the Indian market with that of developed markets, like the United States. The share market of the US is matured, and therefore it makes sense when index funds take up a large chunk of the portfolio. However, the market in India is yet to achieve that state of maturity. Now, while it is advisable to maintain a good mix of index funds (matching the risk profile), it is important to not overlook the value of an active fund as well as the power of mid-caps and small-caps. Thus, it can be said that individuals should focus on putting money in the right mix of index funds i.e. invest in pure index funds instead of large cap funds.
Who should invest in Index Funds?
Index funds are ideal for investors whose risk-taking capacity is low and are seeking predictable returns. There is no need for extensive tracking when it comes to index funds. The returns coordinate with the upside that the particular index sees. However, if one is looking for returns that beat the market, then it is advisable to go for actively-managed funds. For a short while, the returns of index funds may match that of actively-managed funds. However, in the long term, the latter tends to perform better.
Based on how the market is performing and the way it is expected to behave in the future, there could be a large inflow of money in the top 100 companies through index funds. People can gradually start shifting about 20% of their portfolio towards index funds. However, such an action must only be taken after the investor has a solid asset allocation strategy in place. It is important to factor in one’s risk appetite and how close the individual is from realizing his or her financial goals.
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