Last Updated on June 22, 2021 at 10:16 am
In this article, we discuss why it does not make sense to invest in an index fund that does not track the top 100 stocks or lesser weighted by market capitalization. In other words, not all index funds are the same!
We shall not discuss ETFs here as they come with their own problems of liquidity: large sustained deviations between price and NAV. See ETFs vs Index Funds: Stop assuming lower expenses equals higher returns! Also, the problems of tracking a large basket of stocks apply to ETFs too.
Let us take the one-year return difference (fund return minus index return) of different index funds (direct plan funds). This number will typically be negative (not always!). The Data presented here is sourced from the Index fund tracking error screener June 2021 and is as of June 11th 2021.
- Among five Sensex index funds: the lowest return difference is -0.46%. The next highest is -0.9% and above. Please note the more negative the number higher the deviation from the index (including dividends).
- Among 16 Nifty index funds: Only three funds managed to keep the return difference less than -0.5%; Eight funds between -0.5% to -1%; Four funds above -1% and one fund with +1% (it beat the index!).
- Among six Nifty Next 50 funds: only one fund with less than -1% and two funds with well above -2% return difference.
- Axis Nifty 100 Index Fund: -1.11%
- DSP Nifty 50 Equal Weight Index Fund: -1.03%
- The two Nifty 100 Equal-weight indices (From Sundaram and Principal; Soon to be one fund as Sundaram has acquired Principal) clock in well above -2.9% and -2.7%.
- Motilal Oswal Nifty 500 Index Fund: -1.88%
- Motilal Oswal Nifty Midcap 150 Index Fund: -3.1%
- Motilal Oswal Nifty Smallcap 250 Index Fund: -4.2%
Observations:
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
- As the number of stocks increases, the deviation from the index increases.
- If the weights become equal instead of determined by market cap tracking becomes difficult.
- A big difference between tracking 50 equal-weight stocks and tracking 100 equal-weight stocks.
- The deviations do not scale with the expense ratio. The average deviation for Nifty funds is about -0.7%. Motilal Oswal Nifty Smallcap 250 Index Fund has three times the expense ratio of a typical nifty fund, but its deviation is much larger.
Why does this occur? One reason is the poor liquidity of our markets. A way to understand this is via the impact cost. This is a measure of how difficult it is to buy or sell large quantities of stocks. If you wish to buy/sell a large quantity of a stock that is not frequently traded then there would be a bigger mismatch between buy and sell price. This results in deviations from the index.
If we look at the impact cost of the top 100 stocks by market capitalization on the NSE (published monthly) the bottom stocks have high impact costs. This is possibly why it is harder to manage a Nifty 100 equal weight index. A fund manager tracking Nifty 500 or the mid cap or small cap indices would end up buying a few stocks which no other fund house has purchased.
As long as the top 10/15 stocks dominate the weights, the deviation is reasonable. Up to Nifty 100, it is close to -1%. Beyond that, it rapidly increases. The ground reality is, there is no easy to “buy the entire market” passively without suffering loss. Much as the arguments presented in this article – The arithmetic of index investing explained – are enticing, they remain at the time of writing impractical to implement. I am not trying to say passive investing does not work; Just pointing out that venturing beyond Sensex/Nifty comes with a price and beyond the top 100, too high a price.
So what should investors do?
The following recommendations are based on the data available at the time of writing. If things change, then I am happy to change my opinion, but not before.
- Get rid of the idea that buying a larger slice of the market is different. You do not get 450 additional stocks by buying a Nifty 500 fund instead of a Nifty 50 fund. You get additional tracking error at a higher cost. See: Motilal Oswal Nifty 500 Fund: Avoid & stick to Nifty 50 Index funds
- Get rid of the idea that you are capturing different segments of the market by investing in midcap and smallcap index funds. No, you are not. You are just buying more cost and tracking error. A Nifty Next 50 Index fund is all you need to replicate these segments: guaranteed higher risk + potential higher reward:
- Does this mean I can invest in actively managed mid cap and small cap funds to capture returns from these segments? No! This idea of buying something different for something extra rarely comes good! Actively managed midcap and small cap fund struggle to beat the Nifty Next 50!
If you believe in passive investing then all you need is just one or two index funds (stay away from ETFs for long-term investing). A single Sensex or Nifty index fund will get the job done. Those who wish to venture beyond this (with the appreciation of what they are getting into) can consider a Nifty Next 50 Index fund. See: Combine Nifty & Nifty Next 50 funds to create large, mid cap index portfolios.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- 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.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr 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 ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), 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 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 3,000 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 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 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!
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 is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the 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 with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will 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
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published 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
This 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
This is an in-depth dive 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 300 (instant download)