Warren Buffett has rightly said, "By investing in index funds, the know-nothing investors can actually outperform most investment professionals."
If you don't know anything about mutual funds but want to invest in them, then index funds can be the best investment option for you. These are the funds that gave the returns of over 30% since the 2020 stock market crash. Before knowing about the best index funds of 2021, let's understand what index funds actually are.
What are Index Funds?
An index fund is a type of mutual fund or exchange-traded fund with the portfolio constructed to match or track the components of a stock market index, like Sensex or Nifty50. It has the same stocks with the same proportion as present in the index.
Let's take an example to understand it better.
HDFC Bank and Reliance Industries constitute 10.29% and 10.13% of Nifty as of January 2021. An index fund, e.g., L&T Nifty 50 ETF, will have the same weightage as these stocks in its fund.
Why Prefer Index Funds Over Other Mutual Funds?
You should have known about index funds if you have read this so far. Index Funds have the following advantages over other mutual funds:
- Unlike other mutual funds, these funds are managed passively. Hence, they have an Expense Ratio of 0.1% to 0.5% against 1-2% in the case of actively managed funds. This minute difference proves to be quite enormous in the long run.
- Nifty 50 or Sensex funds comprise the stocks with the largest market cap among all. So the portfolio is diversified. The Nifty stocks are generally the leaders of their respective sectors. E.g., Tata Consultancy Services (TCS) is the best company in the IT sector and is part of Nifty.
Why are Index Funds not the Best?
You may think that these funds are the best as they have various advantages. But it is not so. Like a coin has two sides, index funds have their disadvantages too that are as follows.
- The returns provided by these funds are similar to that of the index. So they are not able to beat the market. Actively managed funds may generate relatively higher returns.
- The fund invests in large-cap companies only. So they have low growth potential as the companies are already at their maturity.
- These companies have a high P/E Ratio. So the funds trade at high valuations, which lose the opportunity of finding an undervalued company.
How to Assess Index funds?
Why rely on Google to find the best index funds when you can do it on your own. Following factors should be taken into consideration when analysing and comparing Index Funds:
- The Benchmark Index: All index funds have an underlying benchmark index. There is very little difference in the index funds of a specific index. But the underlying index should be chosen correctly. If you want to get high returns, you should select the Nifty Small Cap Fund. But in case you desire less risk, then Nifty 50 will be more suitable.
- Investment Tenure: Different funds are suitable for different tenures. So it is advisable to compare the returns of the preferred tenure to get a better picture of these funds. It isn't appropriate to compare monthly returns when you want a long term investment.
- Tracking Error: It refers to the difference between the return of the fund's benchmark index and the fund itself. If the tracking error is vast, it is best to avoid such funds as it indicates poorly executed trades by AMC or the benchmark index is very volatile.
- Expense Ratio: It is the annual fee charged by the AMC when you hold a fund. As mentioned earlier, Index Funds have a low expense ratio, lesser than 0.5%. Although they are not very important, they can bring about a massive change in the returns.
Best Index Funds of 2021
Your original aim of opening this article was to know about the best index funds, wasn't it? So your wait is over. Presenting you the best index funds of 2021:
- Nippon India Index Sensex
This 2 Lakh Crores fund managed by Mehul Dama was launched in 2013 and has an underlying benchmark of BSE Sensex. It has given above-average returns of 27.42% in the past year and a CAGR of 12.26% in 3 years, all with a low expense ratio of 0.1%. It has an exit load of 0.25% if redeemed within a week. It is more suitable for long-term prospective (around five years).
- Motilal Oswal Nifty Midcap 150 Index Fund
Although this fund is relatively new, it has proved to be the best index fund for the short-term (1 to 6 months). Launched in August 2019, it has an AUM of 125 Crores. Although the expense ratio and exit loads are 0.38% and 1%, this fund has a massive 33.5% p.a. return in 6 months and a year.
Did you know that this fund manages 1,770 Crores of Assets? This number should be big enough to make you believe that this fund is trusted by people. Although this fund has low short-term returns, it doesn't mean that it is not good. It has shown returns of over 15% in the 3-year and 5-year period. Launched in 2013, this fund has an expense ratio of 0.1% and an exit load of 0.25%.
You would find it hard to believe, but this fund does not have any exit load. It means you can invest in this fund and redeem it the next day without any charge!! But it is highly recommended not to do so. After all, what is the point of investing in the mutual fund for a day?
Anyway, this fund is managed by Sumit Agarwal and Arpit Kapoor and has generated above-average returns in the long run with a low expense ratio of 0.16%.
As index funds mimic the index, the returns offered by them are similar to the movement of the index. That is why these funds can generate good returns with lower risk.
The expense ratio and tracking error are generally low. But they are not able to beat the market and trade at high valuations, besides having low growth potential.
You should consider the benchmark index, investment tenure, and expense ratio to find your ideal index fund, rather than blindly agreeing to everything the stock market experts say.