Index Fund Advantages and Disadvantages

Pros and Cons of investing in Index Funds

Introduction

Index mutual funds have portfolio matching/tracking a particular index like NIFTY 50, SENSEX, etc. Index fund investing is also known as passive investing as the investor does not actively have to pick stocks from the market. It is one of the safest investment instrument since it has lower expense ratios and suitable for low risk investors. In this blog, let us discuss the pros and cons of investing in Index funds.

Advantages of investing in Index funds

• The main advantage of index investing is that it entails a disciplined investment approach and investors/fund managers do not usually try to time the market.
• Since the portfolio is based on particular index, there is less churning of portfolio which saves brokerage costs. Also since there is minimum fund manager involvement, expense ratios are also minimum.
• Index ETFs are a better choice than funds. NIFTY 50 is a safer index to invest as compared to NIFTY Next 50. Nifty Next 50 is a bit aggressive as compared to NIFTY 50. So if a investor wishes to allocate to mid-caps , he/she can have certain allocation to NIFTY Next 50 index funds/ETFs.
• Another good index that investors can choose to track via index funds/ETFs is NIFTY 50 Value 20. It is not widely distributed but it had stellar performance record till last year, beating NIFTY 50, NIFTY Next 50, SENSEX and other large cap actively managed fund’s returns.
• Along with having lower expense ratios, index funds are also super tax efficient. Unlike active funds, an investor does not need to switch the funds depending upon its performance . This helps in saving huge amounts of taxes (short term capital gain taxes).
• For conservative investors who wish to have equity asset class exposure, index fund investing is an ideal strategy.

Although index funds are an ideal investment instrument for conservative investments, they also come with their set of disadvantages. Let us take a look at the disadvantages of index investing.

Disadvantages of investing in Index funds

• Index funds offer a good exposure to large caps, however there are fewer indices offering exposure to small and mid-caps.
• In this case, small , medium and multi-cap actively managed funds have performed much better than index funds. Thus, in these categories fund managers still have an edge over index funds.
• Thus, if an investor with aggressive risk tolerance wants to invest for a horizon for 7-10+ years, he/she should go with small and mid-cap mutual funds. These funds offer better returns on a longer horizon. Also it is better to invest in these stocks through mutual fund route instead of direct equity as there is not enough information available to research about these stocks ,for a retail investor.
• Since index funds are not actively managed and most of the indices are market weighted, sometimes a stock that is performing too well gets higher weightage in index. This creates dependency of the fund on the performance of that particular stock. For example, currently Reliance Industries has ~14-15% weightage in NIFTY 50 which is highest. Thus an Index fund/ETF tracking NIFTY 50 will have more dependency on performance of Reliance Industries. If the stock price nosedives in future, index returns will also fall.
• Also, since Index funds have lower expense ratios, these are not that aggressively distributed as compared to active mutual funds. This is because the main income for Mutual fund houses is through expense ratio. Since Index funds have lower expense ratio (lower income for fund houses), mutual fund houses do not have much incentive in aggressively distributing these funds.
• This is also one of the major reasons for lower penetration of passive investing in India as compared to developed countries like USA.

Conclusion

As we have discussed the pros and cons of Index investing, the bottom line is that it is always better for a beginner to start his/her investment journey with Index funds. After the index investment, investor can move up the hierarchy with active mutual funds and then direct equity investments depending on his/her risk tolerance.