With the rise of Index investing or passive investing in India, there is increasing confusion among individuals when it comes to selecting the best Index Funds for their needs. Therefore, this article aims to present a few key points that could be beneficial to the readers in making their decision.
Prior to selecting the most suitable index funds for your needs, it is crucial to have a clear understanding of the reasons behind your decision to opt for index funds.
# If someone told you that Index Funds are for beginners and as you are a beginner and hence adopt index investing or passive investment strategy means you are on the wrong path of advice. Index Funds are for those who are mature, have a passive mindset, and experienced horrific high-cost active funds consistent underperformance. Hence, no matter whether you are a new investor or an experienced investor, having a passive mindset of investing in Index Funds or Passive Funds is the most important aspect.
# It is a common misconception that Index Funds can reduce overall risk. However, this belief is not accurate. Index Funds primarily help in reducing the risk associated with fund managers’ decisions, but they do not eliminate market risk entirely. Market risk always exists and we can’t run away from this. To mitigate market risk effectively, it is essential to employ risk-mitigating strategies such as asset allocation.
# Indeed, it is important to acknowledge that Index Funds may not always meet your expectations regarding returns. While it is true that removing the fund managers’ risk can be beneficial, it does not guarantee consistent or high returns, such as a 10% yield. Economic crises or market downturns can lead to periods of underperformance, where returns may fall short of expectations. Additionally, during sideways market conditions, returns may even turn negative, approach zero, or be lower than the interest rates offered by a bank fixed deposit. Therefore, it is essential to avoid the misconception that index investing will always yield decent returns. The primary advantage of index investing lies in mitigating fund managers’ risk rather than guaranteeing specific returns.
# If you are an investor who solely prioritizes chasing high returns consistently, then Index Funds may not be the best fit for your investment strategy. The reason being, in various market conditions, there are active funds that can outperform Index Funds, some that can perform at par with them, and some that might significantly underperform. As a result, if your primary goal is to consistently pursue superior returns, Index Funds might not align with your investment objectives.
The issue with certain active funds that may be outperforming the index is the uncertainty surrounding the consistency of their outperformance, which remains unknown both to investors and even to the fund managers themselves.
# With the growing market opportunity and the increasing popularity of index funds, numerous index providers are introducing numerous indices. Simultaneously, mutual fund companies are offering corresponding index funds as well. However, it is essential to be cautious as not all index funds may be suitable for your needs. It is advisable to steer clear of 99% of the indices or index funds provided by the financial industry. Instead, focus on selecting just one or two funds that align with your investment goals. Attempting to invest in all available index funds in the market might lead to becoming an unwitting victim of the mutual fund industry.
# Stop your focus on STAR ratings. As previously stated, the concept behind embracing Index Funds is to reduce costs, find contentment in Index returns, and steer clear of prolonged underperformance by fund managers. Consequently, refrain from considering star ratings.
# Steer clear of any complex factor-based indices. While they may demonstrate short-term success, no strategy can maintain consistent performance over time. It is wiser to invest in the entire market rather than depending on luck-driven factors.
How to choose the Best Index Funds suitable for you?
Now, let’s delve into the process of selecting the most suitable Index Funds for your needs. Ideally, all you require are two funds, such as Nifty 50 and Nifty Next 50. However, if you have an affinity for Mid Cap, you may consider adding the Nifty Midcap Index. Therefore, for your equity portfolio, these two to three funds would suffice. Anything beyond this would only create unnecessary complexity in your portfolio.
# Tracking Error – I have composed a comprehensive article on this topic. If you wish to explore it in depth, please refer to the post titled “Tracking Difference Vs Tracking Error of ETF and Index Funds.” It is quite common for investors and even experts to struggle with differentiating between tracking difference and tracking error. Therefore, it is crucial to grasp this fundamental concept first and then opt for the one that consistently exhibits a lower tracking error. Avoid being swayed solely by recent performance.
# Decent AUM – Opt for a fund with a decent Asset Under Management (AUM). The term “decent” lacks a standardized amount, but I recommend favoring a fund with a higher AUM. This approach indirectly mitigates the risk of tracking errors. Hence, even if a new fund is offered with the lowest expense ratio, try to avoid it whenever possible.
# Expense Ratio – Undoubtedly, we must prioritize funds with the lowest expense ratio. However, it is important to be cautious, as some Asset Management Companies (AMCs) may entice you with initially low offerings and subsequently raise the expense ratio once they reach their desired AUM. Therefore, be vigilant when someone offers a new fund with the LOWEST expense ratio. Instead, opt for a fund that has a track record of maintaining a stable expense ratio without abrupt changes.
The provided information is adequate to help you select the best Index Funds for your portfolio. Embrace a passive mindset and opt for passive funds. Avoid chasing returns or being influenced by star ratings. Stay consistent with your investments and, most importantly, refrain from relying on social media for investment purposes, as it can do more harm than good to your investments.
