Index mutual funds grab investor attention; here’s how to get the best out of them
Investors looking at market-linked returns, reduce the chances of underperformance and not wanting fund manager’s involvement can consider index funds. Index funds with low tracking error and low expense ratio are preferred investment options
Indian investors are becoming more and more receptive to passive mutual funds. As per data sourced from the mutual funds industry body – the Association of Mutual Funds in India (AMFI), the index funds category, one of the two variants of passive funds, was the top among MF categories that registered the highest growth in Assets Under Management (AUM) over the last four years.
The index funds category, which includes both equity and debt index funds, grew at 2,131 percent to Rs 2.3 lakh crore (as of May 2024) over the last four years. Within that, the AUM of equity index funds grew by 1,049 percent during the same period. Meanwhile, the AUM of the other variant of passive funds - ETFs (equity and debt) category rose by 335 percent.
Some of the other categories that grew significantly over the last four years include Multi Asset Allocation Funds (619 percent) and Small Cap Funds (582 percent).
2/9
Index funds are passively managed mutual funds (MFs) that try to replicate the performance of the underlying benchmark. These funds do not require a high level of intervention from fund managers. They just imitate the portfolio of an index, say Nifty 50, by investing in stocks that are a part of the index in the same proportion as in the index.
Exchange traded funds (ETFs) are the other variant of passively managed MFs. Passive funds score over actively managed funds on lower expense ratio and nil fund manager risk.
3/9
AUM growth of the debt index funds stalled after March 2023 as fund houses ceased introducing these funds. Debt index funds are target maturity funds (TMFs) that gained popularity following the successful launch of Bharat bond ETFs.
However, TMFs lost their sheen when the Union Budget 2023 removed the indexation benefits that debt funds enjoyed. TMFs are passively managed debt index funds coming up with defined maturity date like fixed maturity funds (FMPs).
On the other hand, the AUM of the equity index funds has continued to rise thanks to new launches, significant inflows and capital appreciation. Over the last four years, about 100 equity index funds were launched.
Over the years, there has been a notable shift among individual and institutional investors towards passive investment strategies. “This is driven by the growing awareness of the benefits of passive investing, namely, the fact that they are simple, transparent and affordable. I expect this trend to not only continue but gain further momentum in coming years but also resulting in greater adoption and democratisation of investment products," says Vishal Jain, CEO - Zerodha Mutual Fund.
Index funds vs ETFs Both index funds and ETFs have their own advantages and disadvantages. While index funds are provided with an SIP facility, ETFs do not offer an SIP option. Investors in ETFs can access real-time NAVs, while investors in index funds can only access NAVs that are disclosed at the end of the day like any other mutual fund schemes.
6/9
Total cost of ETFs increases due to spread and broking charges While regular plans of index funds charge total expense ratio (TER) ranging from 0.25 percent to 1.09 percent, direct plans of index funds charge 0.05 percent to 0.78 percent. With ETFs, this is not as simple as it seems. “The total expense ratio is not the only cost an investor of an ETF incurs. What we need to look at is the Total Cost Ownership (TCO), which includes expense ratio and other costs such as brokerage, spread, NSDL charges in demat account, etc," says Anil Ghelani, Head Passive Investment and Products at DSP Mutual Fund. The expense ratios of ETFs tracking the Nifty 50 index were 0.03 - 0.15 percent. If you calculate the TCO for these ETFs, then it would increase to 0.45-0.57 percent.
Interestingly, the direct plans of the index funds score over the regular plans of those index funds as well as the ETFs on the cost front. Direct plans do not come embedded with distribution cost. ETFs these days offer a lot more choices. But unless fund houses appoint and nurture more market makers to create liquidity, direct plans of index schemes may well hold the edge over ETFs over the long term.
Index funds are suitable for those new to equity investing. Investors looking at market-linked returns reduce the chances of underperformance and those not wanting fund manager’s involvement can consider index funds.
Index funds with low Tracking Error (TE) and low expense ratio are preferred investment products. Investors must focus on building meaningful asset-allocation based on their own risk-return profile and needs. Therefore, diversifying a portfolio into various asset categories is one of the best risk mitigation tools, and this reduces overall portfolio risk. The easiest way to implement this is through passive products like ETFs and Index Funds, advises Jain. Investors who wish to invest in the index funds can consider two schemes that are part of the MC30, a curated basket of 30 investment worthy mutual fund schemes.
