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Index Funds and Exchange-traded Funds(ETFs), What type of investment is best for beginners?

There is no point in arguing when the greatest investor of all time Mr.Warren Buffett says Index funds are the best way for everyday investors to grow their money. Buffett is a huge fan of Vanguard, the creator of the index fund, for simple, low-cost, and high-performing options.

We have already learned that investing in equity is the best tool to grow health abundantly. But how to pick the right stock is the obvious question. Legendary investors like Mr.Buffet and Mr.Charlie Munger have mastered the art of stock picking using their own theories. How about an alternate option for an average investor who doesn’t know the basics of stock selection? Yes there comes index funds.

What is an Index fund and how is it different from a mutual fund? An Index fund is a kind of mutual fund which mimics a particular index, for eg the HDFC index Fund which copies the NIFTY index and it distributes the Money flows in equal proportion to NIFTY 50 companies. Its returns are based on the NIFTY 50 returns. Capital Allocation to index funds is based on the free-float market. But unlike mutual funds, there is no team of fund managers who pick and manages the stocks. Index Funds put the money directly into a basket of stocks which forms the index. Also, there is no need to pay exit load and fee to fund managers if you choose to go with an index fund compared to mutual funds. In simple words, we can say these are passively managed funds where the fund manager does not pick stocks on his own but he distributes capital to companies constituting the index in distinct proportion. Some other examples include UTI NIFTY INDEX fund which follows the NIFTY 50. ICICI PRU NIFTY NEXT 50 INDEX fund, SUNDARAM SMART NIFTY 100 EQ WEIGHT fund which follows NIFTY 100.

Difference between an Index fund and an ETF?  

Like the name suggests, ETFs or Exchange-traded funds can be purchased only through stock exchanges like our BSE or NSE. For example, If you are using Zerodha, you need a kite app to purchase stocks and a Coin app to purchase mutual funds i.e if you are purchasing mutual funds then you are not directly involved with the stock exchange but you are giving money to a mutual fund house or Asset management company. ETFs can’t be purchased from Asset management companies. Like a company does its IPO and offers a certain amount of its shares to the market, mutual funds house issues or offers a certain amount of units of an Index ETF that could be traded and its units are fixed. So always get clarity from the liquidity point of view before going for an ETF. Liquidity could be a problem for ETFs compared to Index funds.

In a nutshell when an investor sells an index fund then the AMC will see the stocks in the markets and Corpus is paid to the investor thereby decreasing the number of total units. On the other hand, when an Investor sells an ETF, he goes directly to the market and the buyer in the market will buy the ETF.

There are various advantages of investing in an index fund like a low expense ratio ranging from 0.2% to 0.7%. Also, there are no issues of bad stock selection and it’s really easy to understand and select stocks. Saving tax is another benefit if you stick with one ETF for a longer period of time rather than switching between multiple active funds paying extra tax on returns.

Over the past few years, globally and in India, there has been a significant shift from actively managed funds to passive funds i.e. Index funds or ETFs. The rationale for the shift is that the USP of actively managed funds, which is outperforming the comparison benchmark, is not happening. In that case, there is no logic to pay the relatively higher expenses charged by actively managed funds. Cheaper funds, with index-hugging performance, are good enough.

Well, there are certain disadvantages as well for index funds which include No flexibility of stocks selection over any period of time which could result in sticking with bad performing stocks over a certain period of time leaving no choice. The returns will be just average like index returns i.e no possibility of above-average returns. Like any other fund, it holds all the risk of equity investments with no exceptions.

Another problem with index funds are certain companies which are having a heavy weight on the index contribute to more allocation, now there could be advantages as well as disadvantages for the same. Let me take an example to make you understand this situation. Certain businesses like HDFC bank, Reliance Industries, and  Infosys hold more weightage in the nifty 50 index. Considering the time period from January 2020 to October 2020 Reliance has given returns over 50% which is quite good because of its heavy weightage, Now imagine the opposite situation of Reliance Industries giving negative returns.

One more disadvantage of an index fund is tracking error. There could be errors in tracking an index as there are possibilities of replacement of stocks from the index based on proportion. Some other reasons include 

  1. Time difference between accepting investments and buying stocks i.e the stock prices may fluctuate in between the time of acceptance and actual investment time.
  2. Indices are not dividend adjusted.
  3. Cash proportion management and rounding of stock units.

Why Are index funds so famous in foreign countries like the United States and the United Kingdom compared to India?

Well the US and UK are developed markets that are more effectively managed and dominated by Institutional investors. Developed markets have long-term savings of their citizens getting invested into the market regularly which is positive for the economy. Developed countries Indices are broader and they happen to beat other funds easily because of broader indices and diversity. Broader indices are yet to be followed by the Indian markets. Indian index funds have not matured to give such an exit expense ratio of 0.2 to 0.5% compared to foreign markets. There are around 30-35 indices in India. For exploring further about the indices developed in India please visit the site https://www.niftyindices.com.

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