The basics of index fund investing: What you need to know

Introduction

Before diving into the world of index funds let’s see what one of the best investors in the world has to say about it. 

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“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” 

— Berkshire Hathaway shareholder letter 1993

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“A low-cost index fund is the most sensible equity investment for the great majority of investors.”

_{Source: The Little Book of Common Sense Investing, 2007.}

Buffett has consistently maintained his endorsement of index investing. In 2020, he reiterated his stance on the matter:

“In my view, for most people, the best thing to do is to own the S&P 500 index fund. People will try and sell you other things because there’s more money in it for them if they do.”

 _{Source: Berkshire Hathaway Annual Shareholder Meeting 2020, courtesy of CNBC.}

If Warren Buffet has a such firm belief in index fund investing then there must be truth to it. In this post, we are going to study what index funds are and how by investing in index funds investors can achieve more by doing less.  

 Let’s dive deep into the world of index funds:

What is an index fund? 

It is a type of mutual fund or ETF with the sole purpose of matching or tracking the financial performance of indices, such as NIFTY50. These funds provide complete market exposure to its investors. Let’s first understand how the index is constituted. NIFTY50 is the index that contains the top 50 companies of the Indian market by market cap. These companies are of top-notch quality with strong finances and good management. This composition of NIFTY50 is reviewed every six months in January and July. Companies that no longer meet the criteria for inclusion in the index are taken out of the index and in its place new companies are taken into the index. 

So you can be sure that index contains the best companies and by investing in index funds you can be sure that your money is being invested in the best companies. 

A NIFTY50 based index fund will track companies in NIFTY50 and A NIFTYNext50 based index fund will track companies in NIFTYNext50. 

Some characteristics of index funds are:

1. It is a passive investment style
2. track the performance of a specific market index
3. provide broad market exposure
4. simply track the performance of a specific index
5. are low-cost
6. are easy to understand

Some examples of index funds in India are the following:

1. Motilal Oswal Nifty 50 Index Fund
2. Nippon India Index S&P BSE Sensex
3. HDFC Index S&P BSE Sensex Fund
4. UTI Nifty 50 Index Fund
5. Motilal Oswal Nifty Next 50 Index Fund

If you want to learn more about indices you can click the link below:

Why invest in index funds?

Today there is no dearth of social media channels that claim to give stock selection picks with multibagger possible returns. You might have come across such channels where as soon as stock takes off 10-20%, they immediately share profit screen with flying rockets emojis. But the question remains if they are so good with their stock selection picks then why do they need to run a subscription based service? And if their stock selection picks are performing so well then why are 95% of retail traders losing money? 

To stay ahead of 95% of retail investors all you have to do is generate positive returns on your portfolio. Read this statement again and let the severity of the financial condition of retail investors in the stock market. 

A retail trader doesn’t have time to analyze business developments, read multiple annual reports, go through multiple conference call transcripts or track developments of business. You need a simple strategy that does two things first, it generates a reasonable return for your investments and protects you from financial ruin. This is exactly where index fund investing fits in. Index funds can generate 11-13% returns for you in the long run. This rate of return is more than enough to keep you ahead of 95% of retail investors. And during a market crash index funds limit your losses as compared to individual stock investments as indices usually fall lesser as compared to individual companies. 

During a market crash, you can also buy more of the index fund as it will go up in long term but that can not be said about individual stocks as stocks can go down to zero and ultimately get delisted from the stock exchange. 

The churn ratio of NIFTY50 is 68% in 18 years. Only 13 companies have managed to be part of the index throughout. The rest of the companies have either lost the market cap to competitors or have been delisted after financial debacles. 

To summarise here are 8 reasons why you should consider investing in index funds:

1. Simplicity: It is a simple path to success. 
2. Diversification: Reduces risk by investing in a wide range of companies.
3. Low fees: Lower costs compared to actively managed funds
4. Consistent performance: Historically matches or outperforms actively managed funds
5. No need for extensive research: Simply tracks a particular index.
6. Reduced risk: Provides exposure to entire markets or sectors.
7. Long-term investment strategy: Encourages a disciplined, long-term approach to investing.
8. Scalability: Index funds can be easily scaled up or down, making them suitable for investors with different investment goals and objectives.

Types of index funds

Index funds can mainly be divided into two categories:

1. Equity index funds (tracks specific index)
2. Debt index funds (tracks corporate or government bonds)

Equity index funds can further be divided into categories as below:

1. Nifty Index Funds: These funds track the performance of the Nifty 50 Index, which comprises of the 50 largest companies listed on the National Stock Exchange (NSE).
2. Sensex Index Funds: These funds track the performance of the BSE Sensex, which comprises of the 30 largest and most actively traded stocks on the Bombay Stock Exchange (BSE).
3. Nifty Next 50 Index Funds: These funds track the performance of the Nifty Next 50 Index, which comprises of the next 50 largest companies after the Nifty 50 Index.
4. Bank Nifty Index Funds: These funds track the performance of the Bank Nifty Index, which comprises of the 12 most liquid and large capitalized banking stocks listed on the NSE.
5. Midcap Index Funds: These funds track the performance of the Nifty Midcap 150 Index, which comprises of the 150 most liquid mid-cap stocks listed on the NSE.
6. Smallcap Index Funds: These funds track the performance of the Nifty Smallcap 250 Index, which comprises of the 250 most liquid small-cap stocks listed on the NSE.

Performance of index funds

The performance of an index fund depends on two factors:

1. Which index are they tracking and
2. What is their tracking error

Tracking error is the difference between the return of an index fund and the return of the index it is tracking. It is a measure of how closely the fund’s performance aligns with the performance of its benchmark index. 

Since the performance of any index fund is linked to the index that it is tracking, let’s look at the historical performance of various indices:

Index	Return	Total Return (incl. dividends)
NIfty 50	10.97	–
NIfty Next 50	14.74	–
Nifty 100	15.07	16.72
NIfty Midcap 50	11.73	13.21
Nifty Midcap 100	18.29	19.99
NIfty Smallcap 50	8.15	9.37
Nifty Smallcap 100	12.08	13.48

• All returns are since the inception of that index.

Risks in index fund investing

1. Market risk: Index funds are exposed to the risks of the underlying market, and a general market downturn can lead to a decline in the value of an index fund.
2. Tracking error: The fund’s performance may not perfectly match the performance of the underlying index due to tracking errors. These errors can arise from differences in fees, expenses, and portfolio construction.

Conclusion

Index funds are well suited for investors who want to invest in the stock market but don’t have the time or expertise to manage their portfolios actively. An index fund has a very simple methodology for investing, they simply track a specific index. Since they don’t need to be actively managed they have very low expense fees. Investing in an index fund is a prudent way of investing for a retail investor which has also been time and again emphasized by ace investor Warren Buffet. 

By investing in an index fund you can be sure of your money being invested in the best companies. As with any investment, it’s important to do your research, understand the risks and fees associated with index funds, and choose the funds that best suit your investment needs and goals.

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