FAQ on index investing

Published: December 3, 2021 at 7:00 am

Last Updated on December 3, 2021 at 8:40 am

In this article, we discuss some frequently asked questions on index investing aka passive investing.

First the basics. A passive fund is a mutual fund that tracks the stocks in a given index. The fund manager of a passive fund does not make any stock/bond selection on their own. There are two types of passive funds: (A) Exchange Traded Funds or ETFs. You will need to buy or sell these during market hours like a stock. (B) Index Fund. This is like a normal mutual fund where you can buy or sell only to the fund house and the NAV is declared after market hours.

1.  Who should choose passive investing? Anyone who desires a simple but effective low-maintenance portfolio should consider passive investing. It is not suitable for those who tend to compare one fund’s performance with another.

Only investors who appreciate the true meaning of the past performance disclaimer: today’s outperformer need not be tomorrows outperformer will be happy with passive funds. In other words, there will always be some funds that manage to beat the market, the catch is, we do not know which ones! Read more: Why passive investors should avoid making the same mistakes as active investors

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Many passive investors and advocates tend to have a holier than thou attitude about their choices. This is rather immature. The market by definition will have a diverse mix of players, each playing a role to hold it together. While it is one thing to have conviction in our choices, it is immature to carry on with an air of superiority. Discipline and consistency in personal finance can easily trump “sub-optimal” investment choices.

2. India is a developing country so it should be easy to beat the market? Sadly no. Across large caps and mid caps, only 50% of active funds tend to beat the market consistently. Even in the case of small caps, the result is similar if you use a tougher benchmark to beat than a small cap index.

3 Is the emergence of passive funds not a recent phenomenon after the market imbalance from early 2018? To some extent this is correct but a more careful study shows that many active funds have always struggled. See: Poor performance of active mutual funds: Is this a recent development?

4. Index funds or ETFs: Which should we choose? There is much more to passive investing than costs! ETFs have a lower expense ratio than index funds but when we buy and sell and an ETF, we do so at market price and not its NAV. This price can significantly differ from its NAV resulting in a higher tracking error and lower returns. See ETFs vs Index Funds: Stop assuming lower expenses equals higher returns!

We recommend that investors avoid ETFs if they wish to systematically build wealth over the long term. ETFs can be used for trading with small amounts of capital.

4. How to choose an index fund? Here are some simple thumb rules

(a) Do not get enticed by small expense ratios. These are temporary baits to lure in AUM.

(b) Choose a fund with about Rs. 1000 Crores of AUM at least. Low AUM can result in tracking errors: These five index funds beat their indices! Why you should avoid them! In the Indian context, a large AUM can also result in tracking errors, but we think we are far from that point.

(c) Measure tracking error in terms of return difference between the index and fund. The standard tracking error reports depend on the duration and is not intuitive. We publish a monthly screener with both data: Mutual Fund screeners.

Choose a fund with a reasonably low expenses ratio (subject to change!) plus reasonably low tracking error plus reasonably high AUM. Do not waste time looking for “best index funds”.

5. What are the main sources of tracking error in an index fund? AUM in and outflow is the main culprit in an open-ended index fund (all of them at the time of writing are open-ended).

Beyond the top few stocks of Nifty or Sensex, the impact costs are quite high. That is trying to buy or sell large quantities of such stocks will result in a gap between bid and sell price resulting in a deviation from the index. See: Not all index funds are the same! Beyond top 100 stocks tracking errors are huge! Also see: Tracking errors of MO S&P 500 Index fund, MO Nasdaq 100 ETF and FoF.

A constant expense ratio will not contribute to the tracking error as shown by Siva from AIFW and will only reduce the return. Other factors like dividends (which will be reinvested) and other corporate actions will also contribute to the tracking error.

6. Sensex or Nifty which is the better index fund? Since both indices are market capitalization-weighted, there is not much difference between the two.

7. Nifty or Nifty 100 which offers better diversification? Since Nifty 50, NIfty 100, Nifty 200, Nifty 500 or Nifty 750 are all market capitalization-weighted they will not differ much in terms of returns. There are no diversification benefits by choosing Nifty 100 or Nifty 500 over Nifty 50 only higher expenses and higher tracking errors! See: Nifty Total Market Index vs Nifty 50: Which is better?

8. How much NIfty Next 50 should I hold in my equity portfolio? The NIfty Next 50 is more volatile than the Nifty but is not always more rewarding. See: Nifty Next 50 fails to beat Nifty for the last five years: Should I exit?

Also, its volatility has been reducing over the years, meaning its reward could also go down. See: Do not expect double-digit returns from Nifty Next 50 index funds! Also, see: Nifty Midcap 150 beats Nifty Next 50 for the first time

So those who wish to include more than 20% of Nifty Next 50 should be aware of these considerations. If your desire lower exposure then you are better off with either Axis Nifty 100 Index Fund or just Nifty or Sensex.

9.  Should I invest in mid cap and small cap index funds for better diversification? These funds have large tracking errors (see article linked above or our monthly screeners) and therefore quite inefficient. At the time of writing, Nifty Next 50 is relatively a better choice.

10. Can I invest in smart beta or factor-based indices? These are indices where the stocks and their weights are decided by quantitative factors and not market capitalization. Sadly while many of them dressed up to give the impression that they are better than standard indices, no strategy will work all the time.  See for example Data Mining in Index Construction: Why Investors need to be cautious and UTI Nifty200 Momentum 30 Index Fund: Who should invest?

So these are more expensive options with no guarantee of consistent outperformance.

11. Can I invest in an index fund NFO? Please do not. The AUM and tracking errors are unknown at that stage.

12. Can I invest in two Nifty 50 and two Nifty next 50 index funds if my portfolio is large? The answer is subjective. Some people are comfortable with ten crores in the same fund and some people only with 10 lakhs. So if it makes you sleep better spread out the money.

Do you have more questions on passive investing? Reach out to us via email (Subscribe to our newsletter and hit reply to any of our emails) or you can tweet to us.

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