“Most investors, both institutional and individual, will find that the best way to own common stocks (shares) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals.” - Warren Buffett
Mutual fund houses hire fund managers to maximize the return on their investors' investments. However, it’s not always the case that these funds, strategically managed by fund managers, beat the markets in general (you'll see in a while). Then, why not bet on the markets, eh? Enter Index funds.
What are Index Funds?
Index funds are passive mutual funds that aim to create wealth for investors by imitating the performance of an index. As a result of this, index funds may be less hazardous than active funds. Index funds have been popular in the United States for decades now, but India has been introduced to them in 2010 only. Although the country's biggest index fund has Rs. 60,000 crore worth of assets under management, Index funds are still not popular as most of this money is invested by the EPFO and not directly by retail investors like us.
Index funds are, basically, passive mutual funds. Okay, so what are these active & passive funds?
Active Funds have a fund manager who actively investigates the market and selects stocks based on his findings. His objective is to outperform a benchmark in terms of returns and give greater returns to investors over time. He takes a fee from his investors for this service of studying and picking companies using his expertise and other expenses such as personnel salaries, general fund operating expenses, and so on. Also called the ‘Expense ratio’, this is calculated as a percentage of the NAV you own and is charged once a year.
Assume you own 20 units of a fund with a NAV of Rs. 100. If the fund's expense ratio is 1%, 1% of your assets will be deducted each year as fund expenses, reducing your holdings in the fund to Rs 1,980 in this scenario.
Passive Funds/Index Funds: These funds just track benchmarks and have no active manager involved in stock selection and research. As a result, a Nifty Index Fund will purchase all 50 Nifty shares in the same proportion as the Nifty. Changes in the Nifty are mirrored in the index fund that tracks it. Thus, such an index fund will perform similarly to the Nifty. Index funds have lower expenses than active funds since no research is done behind the doors. In India, the average expense ratio for Nifty index funds is 0.2 percent.
You might think that hiring a professional fund manager to buy stocks for you and actively manage your portfolio is a good idea, even if it is a little pricey. However, the evidence suggests otherwise.
Index Funds beat Active Funds
According to a recent story in the Economic Times, during the previous 20 years, 57 percent of active large-cap funds have failed to exceed their benchmarks.
Besides, the founder of Vanguard group carried out an analysis of 335 mutual funds in comparison to the index S&P 500 between 1970 and 2005. And the research had some unbelievable results:
Here’s what the research revealed:
By 2005, 223 funds had to shut down (79.7 percent combined).
60 funds underperformed the S&P 500.
Only 48 funds (13.5%) were able to match the S&P 500's return.
Only 24 funds (6.8%) outperformed it.
Yes, that’s true. Only a mere 6.8% of mutual funds outperformed the index. So, considering index funds have the probability of beating active funds, perhaps it does make sense to save some cost by investing in index funds, right? Fine, but…
How to pick Index Funds?
The issue is that even within Nifty index funds, there are numerous possibilities. Almost every asset management company has a Nifty 50 index fund. So, how do you pick one between them?
The cost-to-income ratio.
Because the Nifty 50 index funds track the Nifty index, they all have essentially the same stock portfolio, although their returns differ. All of this is because some index funds are less efficient than others, resulting in a higher expense ratio.
Sachin Bansal, the co-founder of Flipkart, launched a new company named Navi in December 2018. They moved into asset management after achieving success in digital lending and insurance. They've now released their own Nifty index fund.
Navi has embraced a technology-driven strategy, attempting to enhance efficiency to the greatest extent possible. As a result, they've created an index fund with a cost ratio of just 0.06 percent.
This expense ratio is 70% lower than the national average for Nifty index funds. In addition, active mutual funds' fee ratio (about 0.90 percent) is 15 times that of the Navi Nifty Index Fund!
This expenditure ratio is groundbreaking, and it might usher in a new era of ultra-low-cost mutual funds.
So, Navi has a meager expense ratio, but how much money may be saved over time by investing in the Navi Nifty index fund?
When comparing Navi's fund to an average active mutual fund for a Rs 5 lac lump sum investment, you may save a whopping Rs.33 lakhs over the course of 30 years simply by choosing a lower-cost fund. Why not play a good long game, right?
On July 3rd, the Navi Nifty index fund was introduced. You can invest in this fund using zero-commission applications like INDmoney.
INDmoney helps users to track, save and grow their money. Kind of an all-in-one proposition, isn’t it?
“Financial prosperity is impossible without constant planning and management of money.” - Adelaja.
With the ever-increasing human necessities and inflation only adding weight to that, management of money becomes all the more essential today than it was yesterday. Yet, a majority of Indian population aren’t actively planning their finances, let alone managing it! That’s where tools like INDmoney come into play.
IND Super Money App is basically all your money at one place. You can save, invest & track your investments in a single platform. Definitely worth a try.