How Does Index Investing Work?
You all might have seen many people suggesting you to invest directly in the index for hassle-free investing. But, have you ever wondered how does index investing work? If you haven’t you’ll find that out in this post. Also, you will understand whether index investing is for you, and if yes, what to look for in an index fund before investing.
Active v/s Passive Funds
Before we understand what is index investing, we must understand the difference between the two broader types of mutual funds — active & passive mutual funds. Active mutual funds require active management of funds. The fund manager must research properly and actively change the positions of the fund. Passive funds, on the other hand, do not require any active management. It is as simple as that. And due to that the skill of the fund manager does not matter in this case.
Index funds are passive funds. This means that the skills of a fund manager do not matter. At the same time, they take emotions out from investments. An index fund has a set of rules that it has to follow — which is how you would want your investments to be.
Index Fund Basics
The indices which an index fund invests in are Nifty 50, Sensex, Nifty Next 50 etc. For example, a Nifty 50 index fund will move along with Nifty 50 — the returns of this fund will almost match the returns of Nifty 50. How does it achieve this? If you look at the composition of Nifty (image below), any Nifty 50 index fund will try to match that composition.
If any company is thrown out of the index, the index fund must sell that company. Similarly, if a company is newly added to the index, the index fund must buy that company. Now, there might be some error in matching these weights from the fund’s side. This generally happens when the size of the fund is small. If you take the case of the recently launched Navi Nifty 50 Index Fund, which has an expense ratio of just 0.06%, has total assets under management (AUM) of ₹120 crore.
Let’s say that there is a addition of ₹50 crore in a particular month. Now, this is a huge amount if you compare that to the size of the fund. The fund manager has to take care that the weightage is same as that of Nifty even after adding fresh funds. Due to huge swings in the AUM, there is some gap in weightage with Nifty. This gap is known as tracking error. Tracking error will reduce as and when AUM increases. This means that UTI Nifty 50 Index Fund (AUM ~₹5000 crore ) will have a significantly lower tracking error as compared to the Navi Index Fund.
Any index, be it Nifty 50, or Sensex, is rebalanced based on their certain predefined criteria. This means that it will throw out some stocks out of the index, and add others to replace them. Along with this, weightage of existing stocks is also adjusted based on their performance. All this is done through an algorithm — there is no interference of human emotions here.
Let me explain this by using an example. In 2013, Reliance was trading around ₹450 and was flat for 7 years. Meanwhile, ITC was trading around ₹250. Let’s say that you decide to invest ₹1 lakh in each. In today’s terms (2021), the ₹1 lakh in ITC is still ₹1 lakh, while the ₹1 lakh in Reliance is worth ₹6 lakhs.
There is one catch in your portfolio. You can’t add more funds (this is how Nifty & Sensex work). This means that to change weightages, you have to sell one stock and buy another stock with those funds. Now, you can either sell ITC and buy more Reliance, or sell Reliance and buy more ITC.
Most people will choose the second option, but the index does the opposite. If you look at 2013, the weights of Reliance and ITC were 7.12% and 8.58%. In 2021, the weights have now changed to 10.66% and 2.70%. Nifty 50 increases weightages in stocks that are performing well and cuts down poor performing stocks. This is Nifty’s way of cutting the weeds and watering the flowers. By doing so, you Nifty automatically cuts down the impact of losses on stocks like Satyam and Yes Bank.
“Selling your winners and holding onto your losers is like cutting the flowers and watering the weeds.”
— Peter Lynch
If you look at the chart of Sensex since its inception in 1979, it started from a value of 100. As of writing, Sensex has crossed 60,000 in 2021. That’s a 600-bagger in 42 years — over 16% CAGR. And mind you, this does not take into account the dividends. That would add another 1-2% to the total CAGR.
If you were to say that opportunities have reduced significantly over these years, let’s have a look at Nifty 50’s returns, which was established in 1996 (a full 17 years after Sensex) with a value of 1000. As of 2021, Nifty 50 is over 18,000. That has become 18 times in 25 years — a 13% CAGR.
Yes, I agree that the returns have decreased, but so has the inflation. This means that the real returns have more or less remained the same. In the 1980s, inflation was in the mid-teens, while currently it is around 4-6%. This the the reason why returns are decreasing over time, but the real returns (returns – inflation) have stayed almost the same.
If you invest in any index fund, this is what you get. If you look at the US stock market, it has seen two world wars, a great depression, an oil crisis, and what not. It has come back stronger out of all these events. What this tells you is that if a country has strong fundamentals, its top businesses will do well. And by investing directly in the index, you are getting access to the top business of that country.
Another benefit that index funds have is that you don’t have to go through the process of selecting a mutual fund, and changing it from time to time. The index will automatically do that for you. In fact, in developed economies like US and European countries, index funds have done better than most mutual funds.
Every year, S&P Dow Jones Indices does a study on active versus passive management. Last year, they found that after 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92% are trailing the index. (Source)
The reason you are going to mutual funds is because you don’t know what stock to pick. But, you have the same problem in mutual funds. You again have to choose which fund is better, and your odds of doing that are less than one in ten. That is the reason why you are better off investing your hard earned money in index funds.
Selecting Index Funds
Now that you have got a fair idea of index funds work, you might be wondering how you select the right index funds. There are two aspects that you must consider. First, decide which index you want to invest in. You have the option of investing in Nifty 50, Nifty Next 50, Sensex, NASDAQ, S&P 500. If you are investing only in India, invest either in Nifty 50 or Sensex. If you want some exposure to high growth, you can invest in Nifty Next 50 — don’t go below that. For some international diversification, S&P 500 should do the job. You can add some exposure to NASDAQ if required.
Second, choose the right fund for the selected index. Now that you have decided which index you would be investing in, you must now decide which fund you want to invest in. Ideally, you want the expense ratio to be low, but there is also the concept of tracking error which we saw previously. So, your first priority is low tracking error. For that, look for funds having AUM of at least ₹1000 cr. And from these funds, go with the fund with lowest expense ratio.
Index funds are a great way to get your investment journey started. In fact, they also remove the hassle of selecting the right fund. I hope this article helps you get started with index fund investing. Do share it with your friends if you find this valuable.
Till next time.