How to select an index fund (do you really need one?)

Published: June 6, 2020 at 11:14 am

In this article, a set of simple steps for selecting an index fund is outlined for those who need one. Some frequently asked questions on Index funds and ETFs are also discussed.

Let us first tackle the parenthesis in the title: Are there actually investors who do not need an index fund? Quite possibly yes – something that did not strike me earlier.  Consider a young investor who has an EPF or NPS monthly deduction Rs. 7000 a month (ignore EPS). That is Rs. 84,000 a year and towards Section 80C (for reducing taxable income).

Let us say this person can invest another Rs. 7000 a year. Option 1: Invest Rs. 5,500 in VPF (or PPF) and complete the 80C limit of Rs. 1.5L and start a SIP for Rs. 1500 in an index fund.

This sounds “keep it simple” and all that. However, Rs. 12,500 goes to fixed income and Rs. 1500 into equity. Keep this up for a few years and equity allocation in the portfolio would be next to nothing.


Build a complete financial plan with our Robo Advisory Tool. More than 1000 investors and financial advisors use it!
Get free money management solutions delivered to your mailbox! Subscribe to get posts via email! (Subscribers get exclusive discounts!)


New Tool! => Track your mutual funds and stocks investments with this Google Sheet!

Those who have NPS might argue, “I would just increase the equity allocation in NPS” to compensate. Theoretically yes, but practically, that is paying less for active management and ineffective performance: Why you should avoid equity (scheme E) in your NPS portfolio!

Of course, the true passive investing fan would not worry about trivialities such as tax-saving and invest the full Rs. 7000 in an index fund. If you would do this, please comment below.

Option 2: Rs 7000 in PPF, Rs 5,500 in an ELSS fund (which sadly will always be actively managed) taking care of 80C and Rs. 1500 SIP in an index fund. This has a much better starting asset mix – close to Ben Grahams 50% equity 50% debt – although rebalancing is would be tricky.

What about the person who can only invest an additional Rs. 5000 a month? Where should that go? Towards an index fund or towards an ELSS fund for 80C? This is what I mean by “do you really need an index fund?”.

At least for certain investors, until their income grows (and the default EPF contribution would be higher than the 80C limit) it is important to ask questions such as the above with regard to index funds.

How about I add both – an index fund and an ELSS fund? Well, that would be totally unnecessary and you would be buying more of the market.

Questions to consider before selecting an index fund

  1. Do you already own active funds? Then why are you looking for index options? Just in case? That would just add to portfolio clutter. Do not buy index funds unless you plan to gradually shift towards passive investing.
  2. Do you have a financial goal and asset allocation in place? Without this keep it simple low cost investing and all that will not matter.
  3. How many passive (equity) funds do I need? For most people, just one would do. In any case, never more than two.
  4. What kind of passive funds should I choose? Index funds or ETFs? Choose always index funds and never ETFs: See (A) Nippon India ETF Nifty BeES vs UTI Nifty Index Fund: Which is better? (B) ETFs vs Index Funds: Stop assuming lower expenses equals higher returns! (C) Selecting index funds: Lowest expenses does not mean lowest tracking error!
  5. Which index fund should I choose? Sensex or NIfty? It does not matter! If you want proof check out the video below.
  6. How many index funds do I need? Just one – Sensex or Nifty would for most investors.
  7. But I feel I am missing out on other stocks, can I not invest in a Nifty 100 fund or a combination of Nifty and Nifty Next 50?
  8. What about midcap index funds? Stay away. The impact cost and low AUM will lead to noticeable deviations from the Index. Also see: Motilal Oswal Nifty Midcap 150 Index Fund: Should you invest?
  9. What about small cap index funds? Same as above. Also, see: Motilal Oswal Nifty Smallcap 250 Index Fund: Will this make a difference?

Sensex vs Nifty

How to select an index fund

The playing field is narrowed down comfortably enough –

  • no ETFs;
  • one NIfty 100 fund or
  • one Sensex/Nifty or
  • one Sensex/Nifty  and one Nifty next 50 index fund (high net worth portfolios may need to divide the same index among AMCs)
  1. Avoid looking at tracking errors. These are not easily available, depends on the duration and may not always mean returns closed to index and is not related to expenses ratio:  Lowest expenses does not mean lowest tracking error!
  2. Do not obsess with expense ratios: A fund with lower than normal expense ratio is merely an invitation to invest and increase AUM. Choose the most popular expense ratio among funds with reasonable AUM.
    • For example, Tata Nifty Index fund and Tata Sensex fund with only 41 Crores and 21 crores AUM respectively have an expense ratio of only 0.05%
    • 0.1% is the expense ratio among other Sensex and Nifty funds with 25-30 times more AUM.
    • Avoid the Tata fund because the 0.05% Exp ratio is only an invitation to invest and unlikely to last. The low AUM would mean the index fund could actually beat the index! See: These five index funds beat their indices! Why you should avoid them!
  3. Have the courage to just pick one from the above list with 0.1% Exp ratio: Nifty/Sensex funds from HDFC, ICIC and UTI.
  4. If you want to do more analysis compare last 1Y, 3Y, 5Y returns of these funds with respective indices (TRI data) and choose a fund that is able to consistently keep return difference with index small. I shall be publishing a monthly data sheet for this (details later today)
  5. If you look at the star ratings of index funds you should avoid passive investing, pretty much all MF investing
  6. If you get swayed by news like this: After the market crash 80% of active large cap funds outperform Nifty and Nifty 100, index funds are not for you.

That is about it. Anything more than this would be a waste of time. Remember chasing after the best index fund is just as harmful as chasing after five-star active funds.

Do share this article with your friends using the buttons below.

Use our Robo-advisory Excel Tool for a start-to-finish financial plan! More than 1000 investors and advisors use this!
  • Follow us on Google News.
  • Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
  • Join our YouTube Community and explore more than 1000 videos!
  • Have a question? Subscribe to our newsletter with this form.
  • Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.

Get free money management solutions delivered to your mailbox! Subscribe to get posts via email! (Subscribers get exclusive discounts!)
 
Explore the site! Search among our 2000+ articles for information and insight!

About The Author

Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over nine years of experience publishing news analysis, research and financial product development. Connect with him via Twitter or Linkedin or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation for promoting unbiased, commission-free investment advice.
  Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter what the market condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course!  Increase your income by getting people to pay for your skills! More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts you and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!   
Our new book for kids: “Chinchu gets a superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both boy and girl version covers of Chinchu gets a superpower.
Most investor problems can be traced to a lack of informed decision-making. We have all made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it and teach him several key ideas of decision making and money management is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or you buy the new Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low volatility stock screeners.
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any paid articles, promotions, PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 199 (instant download)