Okay but laana:
Tell me more about these index funds
10th July 2021
Reading time ~ 4 minutes.
Hi there,
Navi Mutual fund, backed by Sachin Bansal (of Flipkart fame), just launched a very low-cost index fund for the Indian market. So for this week's edition, we thought we'll do a deep dive into their value proposition and talk about what this means for you.
What are index funds?
An index fund is set up to basically mimic a specific index, such as the Nifty or Sensex. It does this by investing in the same stocks that form the index. The idea is that by copying the stocks, you are getting returns that are equivalent to the index itself (without trying to outperform it).
Because Navi has come up with a Nifty 50 index fund, your money will be invested in the 50 stocks that form Nifty. It will also have the same allocation in the 50 different stocks, as Nifty does. For example, if Infosys forms 7.5% of the Nifty Index, 7.5% of your money will go to Infosys in an index fund. If a new stock enters the index, then the fund will also buy into the new stock, and drop the stock that has been removed from the index.
Since an index fund basically mimics an index, it comes under "passive investing" - i.e. no fund manager is taking decisions on which stocks to buy and which to drop. The fund is passively maintaining and matching the stocks that form the index.
If a fund manager is actively taking decisions, and using their expertise to make a call on which stocks to hold and which to drop, it's called "active investing." Your other regular large-cap, mid-cap, small-cap equity mutual funds, come under active investing.
Cool, now that we understand the basic structure of the Navi Index Fund, let's go through their value prop (as stated on their website):
"Providing an opportunity for investors to experience low cost investing, because we believe it's your money and you should get the most benefit out of it!"
Navi's key differentiator is their low cost investing i.e. the 0.06% expense ratio.
P.S: Expense Ratio is the cost that the AMC charges you for managing your funds. In simplified terms, if a fund gives you returns of 10%, but the expense ratio is 2%, your net return will be 8%. Active funds have higher expense ratios (<2.25%) than passive funds - because in an active fund, a fund manager is actually picking and choosing stocks.
Among Nifty 50 index funds, you'll find expense ratios currently between 0.1% - 0.5% (for direct plans), making Navi the lowest cost index fund at the moment.
"80% of actively managed funds investing in the top 100 companies of India gave lesser returns compared to Nifty 50 over the past year. So investing in Nifty 50 gives you a higher chance of getting higher returns!"
They're basically saying that because Large Cap Equity Funds performed worse than the benchmark index, investing in a simple index fund (that does not aim to outperform the index) makes sense - it at least guarantees the returns of the index.
If we look at the data from 2020, only 33% of Large Cap funds outperformed the index (over the past 10 years), and this number has been decreasing since 2018. One of the reasons for this could be that in 2018, SEBI mandated Large Cap Funds to invest 80% of their funds in only the top 100 stocks by market cap (the remaining 20% could be invested in other stocks). So now, these fund managers have a limited universe of 100 stocks that they have to invest in, and everyone pretty much has access to similar information. It's hard to find any specific winning strategies in such a case.
Now, let's say the fund manger is doing great and is in fact a part of the 33% - but because it's an actively managed fund, the expense ratio will be higher, reducing the return in the hands of the investors. So on one hand you have equity mutual funds - where you need to ensure you end up on the 33% side (+choose a fund that aligns with the risk management you are comfortable with) + get returns that are significant post expense ratio. On the other hand, you have low cost index funds - in which you simply expect the benchmark returns.
"Historical performance of Nifty 50 has shown that over a 7 year period, the chances that your money will grow is 100%. So the best way to counter risk and build wealth is to stay invested for long!"
Well, its historical performance and nobody knows what the future returns will look like. And if you're investing in the equity market, you're doing that with the faith that India is growing, businesses will do well, and will continue to grow. You're not really buying mutual funds with a pessimistic long term view. So let's ignore the first bit for now. However, from a risk perspective, if you're investing in an index fund (or any equity fund) - it makes sense to stay invested for a longer time horizon since that will give more time for any short term ups and downs to be balanced out. SIPs are the way to go again!
"Diversification: Since the scheme invests in Nifty 50 index, market volatility is lesser compared to mid and small caps"
An index fund tracking Nifty will have diversification similar to the index itself, so it's worth noting that the top 5 stocks in Nifty (as of June 2021), actually account for 41% of the index, and the top 10 account for ~59% of the total index (see below):
The rest of the 40 stocks, only form 41% of the index. This obviously means that unlike a broader index like the S&P 500, which invests in 500 stocks, an index fund investing in Nifty will have this concentration risk. Unlike an actively managed fund, a passive index fund cannot change its composition to reduce this concentration (this does not mean that actively managed funds would not have concentration risk, but simply that if they identified that as a risk, they could make a change).
So, how do I go about this?
When you're investing in a regular equity mutual fund, the fund manager is trying to beat the benchmark index, and uses different strategies and takes some amount of risk in doing so. With an index fund, the fund is just trying to mimic the index and get returns that are equivalent to the index. If Nifty were to give returns of 12%, the fund will also (almost) match the 12%. Whether you invest in Navi or any other index fund, there are two main metrics that will affect your net return:
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Expense Ratio - we discussed this above. If the fund earns 12%, you'll get 12% minus the expense ratio. This is why Navi's key differentiator is a super low cost index fund (at least lower than the current offerings).
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Tracking Error: This is the difference between the returns of the index vs the returns of the index fund. Basically, if Nifty returns 12%, the index fund may return 11.75%. This difference can occur for a variety of reasons, such as getting the stocks at a different price than desired, keeping some funds as cash balances in order to honor redemptions, etc. Funds employ various strategies in order to reduce this tracking error.
Ideally with index funds, you're going for lower expense ratios and low tracking error.
Navi can promise a low expense ratio, but how will it fare on the tracking error? We don't know, I guess only time will tell.
You can find different index funds, as well as their expense ratios (direct), tracking error, total assets in this handy link.
Thoughts? Reach out to me at rujgupta@laana.club
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