Why index funds are perfect for retail investors

It has the long-term benefits of wealth creation, dividend income, tax benefits on capital appreciation and liquidity.

By Madhavi Vora

The best way to own the country’s top stocks would be through an index fund. It is the most convenient way to replicate and reflect the economic growth of the country. An index fund eliminates fund manager’s risk. It is a diversified transparent investment with low cost and easy to track by just looking at the index of the country. It has the long-term benefits of wealth creation, dividend income, tax benefits on capital appreciation and liquidity.

In today’s times, it is difficult for active fund managers to beat the benchmark index. The rebalancing of the portfolios in these funds takes place at intervals keeping only the quality stocks in the investor’s portfolio. The expense ratio of index funds is also lower than actively managed funds.

Shift from active to passive funds
In advanced countries such as the US, there is a shift of investments from actively managed funds to passive funds. The passive mutual funds asset under management (AUM) in the US contribute more than 50% of AUM in the mutual fund industry while total AUM in India comprises less than 10% of overall AUM in the mutual fund industry. Index funds can also be in different categories such as sectorial, mid-cap, small-cap besides Nifty and Sensex where the investor need not worry about risks arising from single stock since index funds represent a basket of stocks.

The Nifty index started at 1,000 in November, 1995 and it took more than nine years to double. However, the index then showed a rapid rise to 6,000 levels in just three years in 2007 and 9,000 levels in 2015. Currently trading at 11,500 levels, the Nifty index has given 11-fold returns (10.3% CAGR) since its inception. An amount of Rs 10,000 invested in 1995 at a level of 1,000 in Nifty would have yielded Rs 1,15,000 today. In the long term, it has given an annualised growth of more than 50%. The beauty of these funds is their ability to withstand global volatility during the downturns in the market compared to mid/ small cap stocks or single stock exposure.

Growth of index funds
In the last five years, ETF and Index funds have seen a growth from Rs 5,000 crore to approximately Rs 2 lakh crore. The growth of index funds has been almost 25-30 times whereas the mutual fund industry has doubled in the same period. This has been made possible with the government’s decision to invest 15% of the EPFO’s (Employees’ Provident Fund Organisation) corpus and pension fund’s money into the passive segment. Thereby, the segment of this market is ripe and ready for exponential growth.

Currently, the decline in India’s corporate profit/GDP ratio, increasing market cap, growing FII interests and rising number of demat accounts will lead to broader participation in the stock market. Valuations seem to be in favour of investments in index funds. Considering the government initiatives to revive the economy and improve infrastructure developments in the long-run, Nifty EPS is estimated to grow at 22.3% CAGR approximately.

It would be wise for passive investors to go for a Systematic Investment Plan to invest in index funds and approach it in a disciplined manner whereby they can enter the markets at regular intervals and ride the wave of economic growth of India for superior, stable and long-term returns.

The writer is CMD, ULJK