My neighbours Manoj, Roshan and I bumped into each other at a park a few days ago. Manoj seemed a little worried and mentioned that his business had taken a hit during COVID. So, he wasn't sure how he would fund his son's higher education a year down the line.
That's when Roshan said that his parents had done the wisest thing by gifting his daughter an equity index fund when she was born and, as a result, he never had to worry about her higher education. The grandparents already had her covered. Such is the potential of equity index funds.
That's why it surprises me when I see people opting for traditional gifting options such as cash, gold or other assets such as appliances or even cars. Many others choose fixed deposits, traditional insurance policies etc., to build a corpus to secure their grandchildren or children's higher education, wedding expenses etc.
While you may not realize it now, you are actually losing money in the long run by choosing such options as gifts for your children or grandchildren!
Instead, if you follow the footsteps of Roshan's parents and choose the route of equity index funds, you can generate significantly higher returns as compared to other traditional asset classes.
Illustration with an example.
Ever since the launch of the Sensex in April 1979, its value has grown from 100 basis points to 55,500+ basis points, which translates into a CAGR of 16 percent. If you take into account the dividend of 2-2.5 percent per year, the total returns work out to 18 percent + in 42 years!
Considering this, had you invested a sum of Rs. 10,000 when the index was launched in 1979, your investment would have grown to roughly a whopping Rs. 1.04 crores today! Now imagine how much you've already lost by parking your investments elsewhere.
In fact, if you consider the last 10 years alone (August 2011-July 2021), the Nifty 50 TRI index yielded a humongous return of 12.44 percent as compared to Gold that grew at 7.7 percent. The avgerage fixed deposits returns were at 7.30 percent. Considering that inflation during this period stood at 6.5 percent, the real ROI from gold and FDs was almost negligible. So, it was those who invested in index funds that made real gains.
Why passive investing is your best bet for the long-term
Now that we’ve established the superiority of returns from equities, let’s delve deep into what makes it the best choice for new, inexperienced investors.
In case you are wondering what passive investing is, it simply refers to buying and holding stocks, for long periods, and with minimal trading.
Even the legendary investor Warren Buffet says, "By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals."
Index funds track a particular market index, say Sensex or Nifty. So, when you’re investing your money in an index fund such as the Nifty 50, you’re essentially distributing your investment among the top 50 Indian companies (by market capitalization). The index fund will track the performance of the benchmark, Nifty 50 in this case, and will represent a weighted average of 50 of the largest stocks or companies in India.
There are several time-tested benefits of passive investing, and hence, index funds, over actively-managed funds.
Benefits of Passive Investment
Simple Strategy: Investing in an index fund is far simpler and easier to understand and keep track of, as compared to an actively-managed fund that requires lot of extensive research to narrow down the select few stocks you need to invest in.
Nominal Fee: There is no one constantly tracking a basket of stocks to decide on timely buy/sell interventions. An index fund simply follows the index being tracked and, hence, the fund management fee is extremely low compared to active funds.
Transparency: The biggest advantage of investing in equity index funds is that you’re always confident of where your money is going. As the index fund can only invest in the set stocks present in the index, there’s no confusion as to which companies are being trusted for your money.
Tax-efficient: As a passive investor, minimal buying and selling minimizes the capital gains you realize in a year, as you’re in it for the long haul and not for short-term impulsive gains.
Diversification: By its very nature, an index fund is well-diversified. In the absence of investor or fund manager bias, you’re automatically invested in a wide range of industries, and hence, spread your risk.
It’s been observed that actively-managed funds have rarely been able to outperform the market index. Very few funds manage to out-think the market, and that's one of the prime reasons why index funds have gained the trust of even iconic investors like Warren Buffet.
Which index fund should you choose?
Not all index funds are made equal. You’ll inevitably face some level of confusion while choosing which particular index fund to go with. Though there are only a handful of indexes, the number of fund houses offering index funds are anything but!
You need to keep in mind 4 key factors while shortlisting and finally choosing an index fund. Use the following parameters as the basis to make a comparison across the same category index peers (For instance, HDFC Index Fund - Sensex Plan (G) should be compared with the Nippon India Index Fund - Sensex Plan(G) not with Nifty or any other category index fund) and then pick your equity index fund accordingly.
AUM Size: The Asset Under Management (AUM) of a fund is the amount of money being managed by that fund. It indicates the level of trust placed by investors in the fund. Hence, the bigger the fund, the better.
Expense Ratio: However minimal, index funds do have a fee, i.e, expense ratio, associated with them. You should typically go with a fund having the lowest expense ratio.
Tracking Error: This refers to the deviation in returns from the fund as compared to the returns from the index. Again, the lower the better. It should actually be zero but difference of 1-2 percent is fine
Years in existence: This is another simple rule to go by when choosing an index fund. The more time the fund has existed in the market, the better.
Clearly, over longer tenures (typically more than 10 years), an equity index fund will easily outperform any other asset class, and by good margins! Hence, gifting anyone an index fund portfolio is a wise decision since the long-term returns will far outweigh what they stand to gain with cash or any other asset. Not to forget, you’ll also sow the seeds of building financial awareness in them. And that I say is priceless!