The Index Investing Revolution: Why Everyone's Talking About It

What has contributed to the shift from actively managed funds to index investing?

One reason is the general awareness of mutual funds. Mutual funds have become popular. But suppose someone starts an SIP on a friend's advice. And they come across thousands of mutual funds, then they'll find it nerve-wracking. There's a problem of plenty.

With passive funds, you don't have to worry about a fund underperforming. Instead, you know the index will grow over time. And with an index fund, it is easy to get started.

Also, when you buy an active fund, it will underperform at times. Instead, for an index fund, you're paying a low expense ratio and get nothing less than the index returns.

What are the key advantages of index funds over actively managed funds for new investors?

The primary advantage is predictability. Because the problem with actively managed funds is that many times, the fund manager is taking a decision with good intentions, but the results don't come immediately. In the meantime, if the investor is keeping a very keen eye on it, he might get confused.

In the case of index funds, you have no such anxiety. This is the definition of the index. You know that every month, as you put your money, you will get as much, no more, no less, besides the cost advantage.

How can index funds be incorporated into a well-balanced portfolio?

If you're getting started, you can allocate 75 per cent to an index fund. Because many times, most investors' biggest problem is how to start. Which one to choose? If that is stopping you from investing, then just go for the index fund.

When you are choosing an index fund, choose a large-cap fund with the lowest expense. End of the story. You don't have too much variability in performance.

To begin with, I would say choose one index fund. Invest 100 per cent. Once you've done it for a while, then reduce your index fund exposure to 75 per cent and add something supplementary. The biggest lesson for most investors is to get used to the madness of the market. With index funds, you're able to get used to it.

Suggested read: Should I allocate over half of my portfolio to small and mid-cap funds?

Do index funds offer an additional advantage to the portfolio of an experienced investor?

They do, and one should use them. One should leverage index funds. One reason is that most good, long-term portfolios should have a meaningful allocation to large caps. Large caps have proven their worth.

It's difficult to choose a large cap that will beat the index. So, that's one big problem to begin with. The second is that there are very few ways in which a large-cap fund manager adds value to beat the index. And that also translates into a drag on performance on occasion.
So, if you have to invest, every investor should have a meaningful allocation to large caps. And that meaningful allocation means about 40-80 per cent. For your alpha, you should consider a mid-cap fund and a small-cap fund.

So, if you buy a large-cap index fund and supplement it with these funds, that will bring down the cost substantially.

Can index funds sustain their momentum as a popular choice for investors?

Index funds still have to build their case. They have grown in popularity in terms of asset base for a different reason. If you look at the size of index funds and the way they've grown in the last four or five years, it is entirely because the Employees' Provident Fund Organisation and NPS started investing in them.

So, the wholesale money getting invested in index funds has led to their popularity, particularly in terms of asset size. But I really wonder if index funds have gained popularity among individual investors for the same reason.

They still have to prove their worth through a full market cycle. Right now, I'm witnessing a wide variety of index funds. And all index funds are not equal.

I would like to look at index funds primarily as a simple vehicle to gain exposure to a market segment. So, when I think of Nifty, it's my large-cap exposure to the market. When I look at the BSE 500, it's my multi-cap exposure to the market. When I look at a micro-cap or a small-cap index fund, that is exposure to that segment of the market.

I would say gain exposure through an index fund, and for the actively managed allocation, look at the narrower segments. It could well be a thematic fund, if you are convinced of a particular sector and want to supplement your portfolio with that. However, the index exposure should be a large portion of your portfolio.

Viewer's Question

My portfolio is down almost 5 per cent and I would like to invest more during this down period. What kind of approach would you suggest? - MS Murali

If you invest every month and if you have a little bit of liquidity, for fun's sake, you can do it. But these declines keep happening, and if you're doing your SIP, you'll pick them up anyway. And it's very difficult to guess. So, keep putting in money if you want to optimise your returns.

However, make some rules for yourself because when you try to time it and get lucky this time, there's no telling what can happen later. What if the market, after this 5 per cent decline, falls and goes down by another 10 per cent? What will you do then? You just might have regrets.

So make sure you're in it for the long run. In between, if you get an opportunity and are able to deal with such disappointment, then go for it.

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Also read: What are index funds?

This article was originally published on November 29, 2024.