What role do index funds have in your portfolio?

There has been an increasing clamour to move from actively managed funds to passive schemes. Media reports of actively managed funds underperforming their benchmarks have abounded. Moreover, with passive funds being popular overseas and a growing number of Index/ETF NFOs being rolled out by mutual funds, passive schemes are garnering more interest.

Index funds are promoted as being low cost, but that alone cannot be the driving factor in choosing them. The index fund category is doing well over the last couple of years, driven by overperformance in 10-12 stocks of the index. The broader markets, mid and small-caps have lagged behind. However, investors should not forget that this is not the case always. Mid-cap schemes beat index funds from 2014-2017.

Outperformers differ over timeRolling returns throw up interesting observations.  The following data was considered:  three and five-year rolling returns over seven, 10 and 15-year periods as on May 31, 2020. For a like-to-like assessment, we will compare index funds with large-cap schemes. The data shows that large-cap funds gave better risk-adjusted returns as compared to the index funds category.  Not only were the median returns better for large-cap funds, the standard deviation was also lower. Two points in favour of index funds are that the outperformance in large-cap schemes was not very significant and prior to SEBI recategorization, large-cap funds had exposure to mid-caps, thus bumping up the returns.

Cost wise, index funds score high. As per Morningstar, the peer group average net expense ratio as on June 30, 2020 for the large-cap category in the regular plan was 2.30 per cent versus 0.75 per cent for index funds.

With data telling us that there is not much difference in the overall performance over long periods, despite the significant variation in costs, there are a few factors you need to consider before making your choice between active and passive funds.

Within the index funds category, there are sub-categories based on the index the fund tracks. Funds which track Nifty 50 and Sensex have been around for more than 15 years. Funds tracking the Nifty Next 50 index (Nifty Next 50 index consists of 50 stocks from Nifty 100 excluding the Nifty 50 stocks)  are gaining popularity, as they provide exposure to quality mid-cap stocks and also diversification among sectors like financial services, energy, consumer goods, automobiles, pharma. Nifty 50 is more concentrated with financial services, IT, consumer goods and oil & gas forming 78 per cent of the index. There are a few funds which follow Nifty 100, mid-cap, small-cap.

Varying expense ratios

The expense ratio differs for each subcategory. For example, Nifty 50 funds carry expense ratio of 0.3 per cent-0.5 per cent annually in the regular plan, whereas Nifty Next 50 funds’ expense ratio ranges from 0.7 per cent-1 per cent a year, with a few exceptions.

You also need to check the tracking error of the fund, which is the difference in return between the index fund and its benchmark due to fees and expenses. Tracking error typically ranges between 0.1 per cent and 0.2 per cent.

Here are steps to determine if you need to have index funds in your portfolio:

-Active or passive? First you need to figure out whether you want to invest in active or passive funds. If you find it difficult to analyze and decide which fund house and type of scheme to invest in and want to keep things simple, passive funds are a better choice. Don’t simply go in for passive funds because the costs are lower.

-Which Market cap to choose?  Both types of funds have large, multi and mid-cap funds. Choosing Nifty 50 gives you exposure to large cap stocks. Thus, if you want mid-caps in your portfolio, you would need to choose a mid-cap index. A report from S&P Global – The SPIVA India score card (which evaluated the performance of different fund categories) showed that the active mid/small cap categories had the largest outperformance over their benchmark in a 10-year period.

-Are you diversifying sufficiently? Nifty 50 based index funds have had a great run over the last 18 months, but Nifty 50 is heavily biased towards certain sectors and stocks, thus not providing diversification. Concentrated investments tend to be volatile and diversification is a risk management tool that cannot be ignored. Thus, you would need to consider adding other categories to your portfolio.

-How do the fund choices complement your goals? If the goal value is large and you are not able saving the requisite amount, you may need to come out of your comfort zone and choose more risky funds.

My take would be to choose index funds in the place of actively managed large-cap funds and choose a combination of actively managed mid and small-cap schemes. This should take you comfortably through various performance cycles.

Original Source:

Photo Credit: Moneycontrol

Source: Article written by Mrin Agarwal in Money Control

Originally published on: 02 Oct 2020

Original article link:https://www.moneycontrol.com/news/business/personal-finance/what-role-do-index-funds-have-in-your-portfolio-5913351.html

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