If you are a typical millennial investor, three checkboxes that must be ticked when deciding on an investment are simplicity, speed and transparency. So when I was tasked with identifying an investment strategy that fit this box, I could only come up with something I had myself used to enter the world of equity investing – Index Funds.
Index funds are any novice investor’s dream come true! How, you ask?
Investing companies via the index
Indices measure the performance of a basket of securities intended to replicate a certain area/segment of the market. An index fund invests in the constituents of the index it is supposed to mirror.
So, if for example, you want to buy all the 30 stocks of the Sensex without having to place buy orders via a stock broker, you can simply invest in a Sensex-based index fund.
Indices are constructed and reviewed periodically based on carefully selected criteria to ensure that they include some of the best companies in the market segment they are chosen to represent. These companies are expected to grow significantly over a longer time frame. There is complete transparency both in terms of what you’re investing in – these are publicly available indices – and in tracking your fund’s performance. Your tech savvy self has also figured out how to invest in mutual funds via online fintech aggregators with as little as Rs 500 in your pocket. It can’t get any simpler, clearer or faster than that!
Choosing a scheme
How do you choose the best index fund? Simply select a brand that you trust and whose investment principles align with yours. While expense ratios and tracking error are two commonly used parameters used to measure the performance of index funds, I personally feel the exercise to be futile. The expense ratio consists of costs: brokerage, transaction taxes incurred by fund managers, as well as a management fee. Keep in mind that index funds typically have very low management fees as they follow a passive style of investing as opposed to a more active style where a fund manager uses research and expertise to pick stocks. Tracking error is a statistical measure of how much a fund’s returns deviate from the underlying index returns. However, this ratio lends value to only those funds that have a history of three or more years and can be misleading if observed during a short period.
So, if you’re picking a plain-vanilla index fund, pick one whose expense ratio is largely in line with the industry average and tracking error is similar to its peers’ – normalizing the anomalies in months of extreme market volatility that tend to smoothen out eventually.
However, once you are comfortable with index investing and have gained some experience with it, you can explore the vast array of index funds that asset management companies have to offer – many have designed unique index funds in conjunction with index providers such as the NSE and BSE. They are slowly venturing into the mid and small-cap segments of the stock market, formulating factor-based indices and even creating indices around popular themes/sectors such as healthcare or technology that appeal to a different, more risk-taking set of investors. All this and more with the original benefits of index investing remaining firmly intact.
Consult an advisor when in doubt
A great way to start exploring these differentiated index funds is to read about the idea behind their construction and consulting a financial advisor about how you can bring in these ideas as diversifiers into your investment portfolio. You can consider keeping low-cost index funds at the core of your portfolio for long-term wealth creation and experiment with other satellite asset classes such as actively managed funds, global funds, gold or even the most recent craze in the investment universe – cryptocurrency.
Just to put things in perspective for the more data-crunching investors out there, the Nifty 50 Index (the most commonly mirrored index) turned 25 recently and has by and large outperformed all other asset classes with 11 percent annual returns since inception. That means Rs 1 lakh invested in Nifty about 25 years ago, untouched, would have left you with approximately Rs 14 lakh today!