Index Funds and Who Should Invest in Them?

Index Funds are gaining popularity in India as well after becoming one of the preferred investment instruments in the developed world. They have also delivered performance equivalent to their active counterparts while having lower costs involved, a major factor for their rising popularity. Scripbox Founder and COO Sanjiv Singhal shares his thoughts about this new trend:

1) There has been a strong perception in western countries that index funds beat actively managed funds over the long run. How true is that?

Developed markets like the US, Europe, and Japan have seen an increased investor commitment to Index Funds. The Exchange Trade Fund (ETF) further accelerated this trend since 1993, which made index investing easier and also added an additional tax advantage layer. 

Since Index Funds aim to replicate the underlying index (like S&P 500 in the US and say the Nifty or Sensex in India), the cost of managing these mutual funds is low, therefore saving on the management cost.

This principle worked well in developed markets because a large proportion of the markets consisted of institutional money and the institutional funds, at an aggregate, were struggling to perform better than the index due to the higher management cost layer.

2) Is this phenomenon catching up in India as well?

In India, Index Funds and ETFs have started to gain momentum. This is partly led by government-sponsored programs and institutions like the EPFO starting to participate in ETFs. It is still early stages as retail adoption is yet to kick-in a major way.

If one were to look at the top 25 equity mutual funds by size, at an aggregate, these funds have delivered 2 per cent per annum return ahead of the Nifty over the past decade. This is after the management fees of these funds. This can partly be explained by the fact that mutual funds in India are relatively small, compared with the overall market and one can expect “professional fund managers" to do better than retail investors.

3) Should investors explore the option of investing in these funds?

Allocating some portion of your assets to passive funds is not a bad option, as increasingly the gap between active and passive fund returns should converge to index returns.

4) What future do you see for such funds in India?

2018 was an unusual year where active funds failed to beat Nifty. Only time will tell if this is a one-off occurrence. Over the next decade, index funds will gain prominence, but given the track record, active funds are likely to deliver returns better than the index for some time to come.