5 MinsMay 17, 2021
Mutual funds can be broadly divided into two types: Active Funds and Passive Funds. As the names suggest Active Funds are those funds where the fund manager actively manages the portfolio, buying and selling the stocks as per a customised investment strategy. While in Passive Funds, the fund manager creates the portfolio as a replication of a particular index. In other words, the portfolio mirrors the movement of the index. Hence, such funds are called Index Funds. Let us see understand in detail how they work.
What are Active Funds?
In an active fund, the fund manager follows a unique or customised investment strategy for portfolio construction. The investments may be made in stocks across market capitalisation segments (in dissimilar weights), at times with a focussed approach to certain securities, in diverse sectors/themes, and even other asset classes as per the investment mandate of the scheme.
What are Passive Funds?
In passive funds, the fund manager replicates a particular index, say S&P BSE Sensex or NSE Nifty 50 (by holding similar weights to the securities of the respective underlying index).
As per the regulatory guidelines, an Index Fund has to invest a minimum of 95% of its total assets in securities of a particular index (which is being replicated/ tracked by the scheme). In addition to funds tracking the large-cap indices, such as the Nifty 50 and the S&P BSE Sensex, there are a variety of Index Funds that replicate various indices such as the Nifty 50, Nifty 50 Equal Weight, Nifty Next 50, Nifty 100, Nifty 500, Nifty Midcap 150, Nifty Smallcap 250, Nifty Bank Index, S&P BSE Sensex, S&P BSE Bankex, and so on. Some Index Funds even replicate foreign indices.
Note that your investment success will be hinged on how the respective underlying index fares. All the fund manager has to do is ensure that the weights of the securities in the fund’s portfolio are equal to the weights in the underlying benchmark index. Thus, an Index Fund typically never outperforms or underperforms its respective benchmark index. If it does, it is usually by a small margin and it would be on account of the tracking error.
Both, lump sum and Systematic Investment Plan (SIP), transactions can be done in Index Funds.
Why you should invest in Index Funds
Here are some key benefits of investing in Index Funds:
(1) Simple and convenient to understand
Index Funds are simple to understand and keep track of. If you are a new investor and find it difficult to choose the right fund from the plethora of available active funds, then you could consider investing in an Index Fund. Since they mirror the index, there is a case to include Index Funds in your investment portfolio, as a buffer along with the actively managed funds.
(2) Lower risk compared to active funds
Compared to actively managed funds, the portfolio turnover in Index Funds is very low, and hence the risk is also lower as compared to Active Funds. Your returns will always be similar to the returns generated by the underlying benchmark index of your Index Fund. An investor looking to diversify his portfolio, can look at investing in an index fund from at least 3-5 year investment horizon.
(3) Low cost as compared to active funds
Typically, the expense ratio of Index Funds is less than 1% (around 0.8%), noticeably lesser than the actively managed equity funds that may levy an expense ratio even well above 1.5%. The returns generated by Index Funds over the last year, and on a 3-year and 5-year basis have been very impressive and well justifies the expense ratio levied. In contrast, a significant number of actively managed equity-oriented mutual funds schemes across sub-categories have found it increasingly challenging to outperform their respective benchmark in the last year since March 2020 in a polarised market rally and haven’t been able to justify the high expense ratio charged. This, therefore, makes a case to consider including some Index Funds in your investment portfolio.
Conditions to keep in mind
- Unlike Active Funds, Index Funds can never generate higher returns than the benchmark. So, if the benchmark does well, they will do well. But if the benchmark fares badly, your returns may be impacted too.
- When you compare the performance of one Index Fund with the others, understand the investment mandate of the scheme well and its benchmark. You should try and learn about which underlying index the fund will track, the constituents of the respective index, and the investment objective the fund endeavours to achieve.
- Know what your Index Fund’s tracking error is. Tracking error refers to the standard deviation percentage difference, in other words, the difference in the returns generated by the Index Fund and its benchmark. The tracking error of an Index Fund is influenced by the cash held by the fund to handle redemption pressures, plus the inflow and outflow from the fund, and the weight to each security of a respective index.
- Since Index Funds are not traded on the exchange, real-time transaction is not possible. Transactions are executed at the day-end Net Asset Value (NAV) declared by the fund house by approaching the fund house or its registrars.
Index Funds are very popular in developed markets, particularly the United States. In India as well, investors now are recognising the importance of Index Funds in their portfolio. That is why Index Funds have reported decent inflows over the last year. To select an Index Fund suitable for you, from Axis Bank’s list of top-performing funds, click here.
Disclaimer: This article has been authored by PersonalFN, a Mumbai based Financial Planning and Mutual Fund research firm. Axis Bank doesn't influence any views of the author in any way. Axis Bank & PersonalFN shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision