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

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.

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?
   • If you are okay with just 10% or 20% of NIfty Next 50 then NIfty 100 would do. See: Axis Nifty 100 Index Fund Impressive AUM but is it expensive?
   • If you would prefer higher exposure to Nifty Next 50 then you will have to factor in rebalancing (systematic or tactical). See: Combine Nifty and Nifty Next 50 funds to create large, mid cap index portfolios also
   • Nifty + Nifty Next 50: What is a good mix?
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.