What are the Benefits and Limitations of Investing in Index Funds?

Advantages of Index Funds

The unique construct of index funds does provide investors a number of benefits that are not available to those who investing in actively managed funds. Below are the major ones that one should consider: 

1. No Fund Manager Bias

In the case of an actively managed fund, the fund manager and his/her team is responsible for selecting stocks that can help the fund’s portfolio outperform the chosen benchmark. However, this selection of stocks is prone to fund manager bias in the case of actively managed mutual funds. This is not the case with index funds as the stock selection is limited to companies featured on the chosen index. What’s more, the weight of individual stocks featured in the fund’s portfolio is an exact replica of the composition of the index. This eliminates the possibility of fund manager bias in the case of an index fund.    

2. Lower Fund Management Cost

Actively managed funds incur several costs such as a team of analysts to help in analyzing and selecting stocks, brokerage charges whenever stocks in the portfolio are bought or sold, etc., all of which lead to higher fund management charges. These costs are reduced significantly in the case of Index Funds as stock selection is done based on the composition of the Index so the fund management team can be much smaller. Additionally, there is limited requirement of buying/selling stocks in the portfolio. In fact, most indices in India get rebalanced only 2 times in a year, so limited number of transactions are required to rebalance the portfolio of an Index Fund. This typically translates to lower fund management costs resulting in a lower total expense ratio (TER) for passively managed schemes such as index funds.

3. Replicates the Performance of the Index

In the long-term, equity indices in India have marched upwards. While there may have been few bumps along the road be it sub-prime crisis, demonetization, COVID, etc., over a 10-year period or longer, equity indices in India have been able to generate positive returns. So, an index fund that replicates the performance of an index would historically have given comparable returns within a margin of the scheme’s tracking error. So if one stays invested in an equity mutual fund based on an index for the long term i.e. 10 years or longer, there is good possibility that the investor will receive positive return on investment.       

4. Diversification

A majority of Index Funds in India are based on diversified indices that offer exposure to multiple sectors of the economy. So, even if you choose an index fund that is based on a large cap, mid cap or smallcap index, your investments will be diversified across multiple sectors. As a result of limited exposure to any specific sector, the overall risk to the principal amount invested decreases. Moreover, investors investing in broad-based indices also get to enjoy the growth potential offered by different sectors of the economy.   

5. Low Concentration Risk

Indices like the Nifty 50, Nifty 100 and Nifty Smallcap 250 that are commonly replicated by Index Funds are constructed in way that there is limited exposure to any specific stock. This reduces the concentration risk to the scheme’s portfolio and ensures that the upward or downward movement of any single stock has limited impact on the overall value of the investment portfolio. The reduced exposure of index schemes to any single stock or sector helps control the downside risk for the investor to some extent.   

6. Professionally Managed and Convenient

Like other types of mutual funds, Index Funds are also professionally managed by a fund manager and team even though these schemes feature a passive management principle. This ensures that the allocation of investible assets is managed in the prescribed manner as per the scheme’s stated investment objectives. Additionally, index fund investments offer a convenient route for investors who are planning to make diversified long-term equity investments in an index of their choice.