How to choose an index fund in India?

Published: September 5, 2015 at 9:36 am

“How to choose an index fund in India?”, Three people asked me this question in the last two days! My typical response is, “choose a Sensex or Nifty index fund, from the AMC you are comfortable with”.  I thought let me expand my response a bit more.

Should I adopt passive investing in India?

Aarti Krishnan made an interesting point in the September issue of Mutual Fund Insight: Active mutual funds should stop using benchmarks like Nifty, Sensex, BSE 100 etc. which are liquidity based indices and instead should use strategic indices like

 

CNX Alpha (50 stocks with highest alpha),

NSE Quality 30 (companies with sustainable business models)

NV20 (value stocks in Nifty).

Cannot agree more. I will soon incorporate CNX Alpha in my mutual fund risk and return analyzer

If there are index funds which track such indices, it could well be a smart idea to choose these rather than active funds. Alternatively, one could just track these indices manually with a demat account.

So the answer is, yes one can adopt passive investing in India, but with the right index. Not many funds maybe able to beat such strategic indices (which are young) in future.

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Alternatively, choosing a broad market index like CNX 500 (Goldman Sachs has a index fund for this) is also a good idea.  However, many active funds do manage to beat CNX 500 easily.

The argument that alpha (extent of index outperformance) will disappear is true for the fund industry but not for investor folios. People who have significant alpha today with active funds are likely to retain that even if they switch to index investing later. Alpha of the portfolio is what counts.

Should I choose an index fund or ETF?

Stay away from Indian ETFs. In an ETF, you are buying and selling to other subscribers. If not many people are trading at any given time, it would be difficult for you to sell. If you cannot, the AMC after a while (need to see the scheme document – last I checked it was at least a few days), will buy it from you. Why bother?

If you want to follow passive investing, stick with index funds.

How about Nifty and Sensex index funds?

Index investing is for mature people. They recognize that with an index fund, they need not worry about fund manager performance. For them, this factor trumps the fact that active funds easily beat such indices.  As long as they don’t compare their index funds performance with active funds, there is no issue with choosing such index funds.

That said, it is important not to delude oneself that the low expense ratio of the index fund will be a deciding factor in outperforming the more expensive active funds. There is no such evidence of that so far. Unless AMCs have the guts to choose the strategic indices mentioned above, I think expense ratio will not be a factor when it comes  to comparing active funds and passive funds.

So how do I choose an index fund?

Once you decide the index to track and the way in which you are going to track (manually, ETF or fund) it, you can simply choose any AMC you are comfortable with. There is practically no difference in Sensex and Nifty movement. So you can choose what you are comfortable with.

What do you think?

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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
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5 Comments

  1. Sir

    As I understand NIFTY/Sensex ETFs can be purchased only via demat provider. Since their value is dynamic( unlike EOD NAV of mutual funds) , is it a good strategy to invest some lump sum on moments when markets fall drastically ? I know you are pretty much against timing the market but for these scenarios , aren’t they sensible ?

    1. That makes sense when the amount you already have invested is small and comparable to the amount that you wish to invest. After a few years, the value of your investments in the markets will be higher than the amount you wish to invest. Then worrying about that value will become more important than worrying about timing the next investment. Anyway, if you want to time, use a fund and not etf. Time using moving averages and not dips.

  2. Good article sir. How do we calculate tracking error of Index funds or is there any source available, where we can check the tracking error of index funds in India

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