Choosing the correct index fund

Index funds today are great tools for asset allocation. They are low cost, easy to understand, and have proven to be useful for long-term wealth creation. While there are hundreds of ETFs and index funds to choose from in the US and other developed markets, India has a long way to go when it comes to choice. Recently, however, there have been many index launches, and we hope to see many more in the coming future. With the large influx of index funds from multiple AMC’s - how does one go about choosing the right one? What about ETFs? We had to choose between hundreds of active mutual funds, and with index funds coming in - the choices have increased manifold. So, where do you start?

Understand your risk profile: Customers should understand their risk tolerance and adhere to them. Without knowing risk tolerance, an investor becomes aggressive during bull markets and conservative during bear markets, which is a sure-shot way of destroying wealth. Knowing the risk profile enables investors to choose the funds or strategies that they can hold for long-time periods.

Choosing the asset class: Based on a customer’s risk profile - a customer can choose between the many index funds available in the market. For example - a risk-averse customer should not invest too heavily in equities and should ideally have a small allocation to mid-cap and small-cap funds. A risk-loving investor who wants to optimize returns should have a high equity allocation with allocation towards the mid and small-cap funds.

Index funds fall under six main categories - large-cap, mid-cap, small-cap, multi-cap, sectoral, and international. A large-cap index includes the top 100 stocks in India. The mid-cap index contains the next 150 stocks (101-250), and small-cap index funds include the remainder stocks (250+). As an investor, sectoral and small-cap indexes may be very enticing, looking at past returns. Still, it’s crucial to know that they are riskier and more volatile.

For investors looking for safety - go for large-cap index funds (Nifty 50, Nifty Next 50 and Nifty 100). Today - a lot of savvy investors are moving or adding a large-cap index strategy. Most funds over the large-cap category have failed to beat the index, and we expect this trend to stay.

International index funds are another area of interest. The rupee depreciates by 3-5% every year. A global fund provides an excellent hedge as well as it gives additional portfolio diversification. And they are a great way to own stocks like Apple, Google, Amazon, etc.

Choosing the right fund: Investors when choosing the right fund may run into the problem of choice, whereby many mutual funds are offering the same choice. For example - the Nifty 50 index fund is today offered by many mutual funds. Although most of them are very similar to each other - investors should focus on costs (Total Expense Ratio) and tracking error.

Tracking error is the difference between the returns of the index and the returns of the fund. It’s almost impossible for a fund to track or replicate the benchmark perfectly. The cost of trading, tax, and expense ratio lead to a small tracking error every year. What I recommend is that investors watch out for funds with significant tracking errors. Between similar funds - go with the mutual fund house you prefer.

Lastly, what about ETFs? ETFs are an alternative to index funds. The difference between an ETF is that it is traded on the exchange (just like a stock), whereas index funds are mutual fund formats of passive funds. Retail and HNI Investors are better suited to index funds as liquidity on the exchange today is quite poor. As a result - investors buying ETFs pay higher amounts when they buy units and get paid less when they sell units on the exchange.