How to use index funds in your portfolio?

What are index funds?

To understand an index fund, you should know what an index is. An index is an aggregation — a collection of stocks in a certain proportion. Most mutual funds are sold on the premise that they will beat the index. It is generally assumed that the return you get from the index, academically or theoretically speaking, is what the market generates. An index fund is a replica of the index as an investment portfolio and is an unmanaged portfolio.

Suggested read: What are index funds?

What are the pros and cons of investing in index funds?

It is simple and predictable. The Nifty has 50 stocks, Junior Nifty consists of the next rung of 50 stocks after Nifty, Sensex has 30 stocks and then there's the mid-cap index, whose constituents you know are fixed as well.

Indexes are fixed, and your investment performance matches the index. Which means there is little scope for disappointment. Basically, you don't outperform the index, nor do you trail it. Instead, you settle for the average — and that's what an index fund offers.

Also, most index funds have relatively lower costs because a fund manager doesn't actively manage them. Of course, you still get the diversification, convenience, and tax efficiency of a mutual fund. The special advantages over active funds are the predictability, simplicity, and low cost.

However, people invest in equity to beat the market and to do something substantial. So, the biggest disadvantage with an index fund is that you're settling for the average. It is a choice you have to make for the simplicity and the low cost.

Secondly, these indexesare mostly capitalisation-weighted, meaning the larger winners, the heavyweights, dominate the index. Lastly, sometimes there are losing companies in the index that everyone knows will struggle, yet the index fund has to hold them because it has to replicate the index.

How to use index funds in your portfolio?

Most investors can use index funds to their advantage, even if they prefer actively managed funds. Every portfolio should have equity and fixed income, and the equity component should be substantially in large-cap stocks. This could be 40-70 per cent of your portfolio. And this portion should be filled with index funds because, in the large-cap space, it's very difficult to beat the index. After all, active large-cap funds are already struggling to outperform.

If you stuff 40 per cent to 70 per cent of your portfolio with large-cap index funds, there's a guaranteed cost-saving, and the likelihood of outperforming is small. Since index funds have a cost advantage of, say, 0.75 per cent, active funds need to outperform the index by at least 1 per cent to match its returns. So, most investors would do well by filling their large-cap allocation with Nifty, Junior Nifty, or Sensex index funds.

After that, you can diversify into small-cap, multi-cap, or even sectoral funds if you're excited about them. This way, you ensure that a large part of your portfolio is low-cost.

Viewer's question

I am a 78-year-old- mutual fund investor. My only son and his family depend on my monthly pension of Rs 1 lakh. Please explain how I can insert my son's name as a second holder instead of the nominee with an option of either or survivor and add another nominee. This is to make easy transitions after my demise. - Mr Khan

It's complicated, but it's not impossible. At the time of investing, adding a nominee or setting up an "either or survivor" mode isn't too difficult. I could be the owner, and my spouse could also be an owner, and we could jointly own the investment.

For Mr Khan, he can submit a "request change" form. This process isn't digital, so he'll need to contact the registrar, either Karvy or CAMS, depending on where his investments are held. He should ensure that his son is KYC-compliant and then submit the form to add his son as a second holder. After that, he'll receive an acknowledgement, and the change will be made. However, this is a manual process that requires visiting these places or signing the form.

What is the best method to take a tactical call to benefit from the likely ensuing interest rate cut? Should we invest in government securities funds or long-duration funds now or through an STP for the next three to six months? I already have about Rs 25 lakh invested in short-term debt funds for about three years, and the annual returns are about 5.5 to 6 per cent.

If you're convinced about the rate cut and are prepared to handle the risk of being wrong, long-duration funds and government securities are your best bet. This is because these are the first to reflect interest rate cuts, and they do so quickly.

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Also read: The time to be passive is coming

This article was originally published on September 20, 2024.