Your ultimate guide to Index Funds 😌

Index funds may not make headlines, but they have quietly outperformed many actively managed funds over the long term. Here's why

You must have heard a lot of praises about Index Funds 📈

Even the guru of all Investment Managers, Mr. Warren Buffett is a big fan of Index Funds 😮

In fact, he loves Index Funds so much that he has asked his trustees to put 90% of his wealth in S&P500 Index Fund after his death 🤯

Here is everything about Index Funds 👇🏻

1. What is an Index?
   
   An index measures a subset of the stock market, that helps investors compare the market performance over a time period

   
   For Example, in India we have the following indices:

   1. Nifty - Top 50 listed stocks by market cap in India

   2. Sensex - Top 30 listed stocks by market cap in India

2. What is an Index Fund?
   
   Index Fund is a passively managed Mutual Fund
   
   It invests in such a way that it imitates a stock market indices like the:
   

   1. Nifty,

   2. Next Nifty50,

   3. Sensex,

   4. Bank Nifty etc.

   
   Say, Reliance Industries Limited's (RIL) weight in Nifty is 10% and for HDFC it is 7%.
   
   So, the Nifty50 Index Fund will have 10% in RIL and 7% in HDFC.
   
   Similarly, if the weights change to:

   a. RIL - 14%
   b. HDFC - 10%

   
   Nifty50 Index fund will change proportionately to hold RIL at 14% and HFDC at 10%
   

3. Why Index Funds at all?
   

   1. Underperformance by large cap funds

   2. Lower expense ratio

   
   90% of the actively managed large cap funds returned lesser than Index in last 1 year.
   
   That too despite charging 1-2% active management fees.
   
   Since, Index funds are passively managed, their fee generally ranges between just 0.05%-0.35%.
   
   As of 31 Dec'21, 82.3% large cap funds returned lesser than Index for last 10 yrs.
   

4. Is it the same with Small Cap and Mid cap funds?
   
   No!
   
   Only 28% small /mid cap funds couldn't beat their respective benchmarks in last 1 year i.e., BSE Small Cap Index and BSE Mid Cap Index.
   
   So, ideally it seems like choosing an active fund for participation in small and mid-cap companies is still fine.
   
   However, for large cap companies, it is more likely that selecting large cap funds over index funds will be counter-productive.
   

5. What will be my returns?
   
   Nifty50 has returned 12.24% CAGR in last 10 years
   
   But "Yeh dil maange more?"
   
   Nifty stocks also give dividends
   
   Nifty Total Returns Index (TRI) includes dividends also
   
   Nifty TRI has been 13.64%
   
   Will that be your return? Read on 👇🏻
   

6. What are the charges? Expense Ratio
   
   So, there are people and expensive infrastructure required to replicate the Index returns for you.
   
   That comes with a cost.
   
   But thank god, it isn't a bomb!
   
   It varies from 0.05% - 0.35% of your investment value +/- gains
   
   Lower the better, always?
   
   No! Read on 👇🏻
   

7. Tracking Error
   
   Index Funds use algo to trade stocks with respect to the changing proportion in Index
   
   But due to margin/cash liquidity and other reasons, it is not possible to replicate the index absolutely
   
   Tracking Error is the margin (%) by which fund couldn't match Index's TRI return
   

8. How to choose Index Funds?
   
   By placing weightage to both:

   1. Tracking error and

   2. Expense Ratio
      
      I will share a sheet where we've analysed Nifty50 Index funds in this way.
      
      Will be shared in our free community - Link towards the end of the blog

9. Can we save taxes while investing in Index Funds?
   
   In India, Asset Management Companies (AMCs) can not have passively as well as actively managed Equity Linked Saving Schemes (ELSS) Mutual Funds.
   
   ELSS Mutual Funds are the ones which reduce taxable income u/s 80C of Income Tax Act, 1961.
   
   IDFC MF launched Nifty50 Tax saver fund a few days back.
   

10. What are different types of Index Funds in India?

    1. Nifty50

    2. Bank Nifty

    3. Nifty Next 50

    4. Nifty Small Cap

    5. Nifty Midcap

    6. Nifty Equal Weight Index

    7. Sensex Index Fund

    8. Nifty100

    9. Nifty BFSI Index

    10. Nifty 200 Momentum 30

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Disclaimer: Not investment advice. Kindly refer your SEBI registered Investment Adviser before taking any investment decision