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Passive investing gains ground: How do you choose the best index fund?

Fund houses are rolling out new index schemes and ETFs, as passive investing gains ground. But you must choose the right underlying index carefully.

March 19, 2021 / 12:38 PM IST

Aditya Birla mutual fund has rolled out two index schemes. They will track the Nifty Midcap 150 Nifty Small-cap 50 indices. There are exchange traded funds (ETFs) and index funds outside the traditional large-cap universe these days.

Last year’s equity market rise has brought in many new investors to equities. Large-cap funds may have been finding it tougher to beat their benchmark indices, but mid and small- cap schemes have so far not faced much of a problem. To be sure, the extent of outperformance is coming down.

“More money is flowing into the same set of mid-cap stocks. Hence, many actively managed mid-cap funds are finding it challenging to beat their benchmarks,” says Hemen Bhatia, Deputy Head - ETF, Nippon Life India Asset Management.

“There is still some opportunity for alpha generation here, as new and unique companies enter this segment,” says A Balasubramanian, Managing Director and Chief Executive Officer of Aditya Birla Sun Life AMC. However, increasing price discovery can reduce the outperformance over time. Choosing the index route for mid-cap funds in the future is a good idea, says Balasubramanian.

The trick through is to get the index right.

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Choosing the right index fund

There are index funds and ETFs that track Nifty 50, Nifty Next 50, and Nifty midcap 150 among others. These invest in a specific set of stocks. A Nifty 500 index fund invests in a much broader universe.

But can you choose a broader index that would have all three – large, mid and small-caps? There are three such ETFs presently in the market.

Most of the indices follow a market capitalisation method. This ensures that the companies that do well and whose market capitalisation goes up stay in the index; others miss out. That is why many broad-based indices are filled with larger sized companies – medium and small-sized companies do not get much weightage. For example, nearly 70 percent of Nifty 500’s constituents are large-cap stocks (top 100 stocks by market capitalization). “If you wish to invest in mid and small-cap schemes, dedicated passive index funds make more sense,” says Bhatia of Nippon AMC.

Lower risks in index funds

Index funds may be less risky than actively-managed funds, but the volatility risk is still there. Set your expectation right.

Over the last one-year period, mid-cap funds gave 56.12 percent returns and small-cap schemes delivered 67.81 percent returns, according to Value Research. For the good run to continue, the earning recovery has to be strong. Negative surprises can make the market volatile.

Amol Joshi, Founder of Plan Rupee Investment Services says, “Only aggressive investors with a 5-7-year horizon should consider investments in mid and small-cap index funds – just as they would do for actively-managed ones.”

What should you do?

Passive investing is coming with newer avenues. So far, there are four schemes that track the mid-cap index and two, the small-cap space. Liquidity remains a big problem for ETFs and so some MFs see merit in launching index funds based on indices that ought to be part of your core portfolios.

Go for dedicated mid-cap and small-cap index funds, to compliment your allocation to frontline index funds tracking the Nifty 50 and Nifty Next 50. If you cannot decide your allocation, stick to schemes like Mirae Asset India Equity Allocator Fund of Funds and Nippon India Passive Flexicap fund of fund. Passive investing in mid and small-cap spaces is still evolving. So, there may be no established track record to go by.
Nikhil Walavalkar
first published: Mar 19, 2021 10:25 am

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