How to select the right index funds for your portfolio?

Index funds are growing in popularity among retail investors in India. Assets under Management (AUM) in index funds stood at over Rs 2 lakh crores as on 31^st January 2024, growing 13X in last 3 years (CAGR of 137%, source: AMFI). There are several benefits of investing in index funds like lower costs (TER), no unsystematic risk, no human biases, convenience, transparency etc, which make these products suitable for both experienced and first time investors. Furthermore, unlike exchange traded funds (ETFs), you do not need to have Demat accounts to invest in index funds. In this article, we will discuss how to select to right index funds for your portfolio.

You may also like to read: All you wanted to know about Index Funds

Selecting the index / category

Index funds are passive funds which track market index. Unlike actively managed funds, index funds do not aim to beat the benchmark index; they simply track the index. Among index funds, the most popular products are funds tracking the Nifty 50 and Sensex; index funds tracking Nifty and Sensex have a large share of overall equity index fund AUM. The passive space has evolved and matured significantly over the last few years in India. There are many choices for investors now.

• Funds tracking broad market indices: The most popular broad market indices are Sensex, Nifty 50, Nifty 50 Equal Weight, Nifty Next 50, Nifty 500 etc. We will not discuss the composition of specific indices in this article. Suffices to say here that the broad market indices will give you broad exposure across different industry sectors. If you want to get exposure to specific market cap segments, you can invest in funds tracking Nifty 100 (large cap), Nifty Midcap 150 (midcap) and Nifty Small Cap 250 (small cap) indices. Different market cap segments have different risk profiles. You should invest according to your risk appetite and consult with your financial advisor if you need any help. Index funds tracking broad market indices can be suitable for both experienced and new investors.


• Funds tracking sector indices: If you can also take sector exposure through index funds which track different sector indices e.g. Banks / Financials, FMCG, Infrastructure, IT, Pharma, Automobiles. PSUs etc. Investment experts recommend index funds over active funds for taking exposure in certain industry sectors, especially sectors which are dominated by a few large companies. Investment in sector index funds requires knowledge of the relevant sectors. As such, these funds are more suited for experienced investors, who want a satellite allocation to the core equity portfolio. You should consult with your financial advisor, if you need help in understanding risk factors in specific industry sectors.


• Funds tracking strategy indices: Index funds tracking strategy indices provide low cost investment opportunities to different investment strategies that are based on quantitative model, free from human biases. These indices are known as smart beta indices and are constructed based on quantitative, rule based investment strategies e.g. dividend yield, momentum, value, low volatility, high beta, alpha, quality etc. Index constituents are selected based on defined quantitative models. Index funds tracking these indices are known as smart beta funds. Smart beta indices can be a based on a single factor model e.g. dividend yield, momentum, high beta, low volatility etc, or multi-factor models combining Quality, Value, Alpha and Low Volatility. Examples of multi-factor strategy indices are Nifty 50 Value 20, Nifty Alpha Low Volatility 30 etc. Investments in smart beta funds require understanding of the strategies used, but they can be very useful from a portfolio diversification perspective. These funds are also more suited for experienced investors.

Look beyond equities for asset class diversification

Many investors associate index funds with equities. You should know that index funds associate diversification opportunities in other asset classes – through index funds you can get low cost exposure to fixed income and international equities also.

Suggested reading: How can Index fund play a key role in the diversification of a portfolio?

• Fixed income: The most popular fixed income index funds are target maturity index funds. Target maturity index funds are open ended passive debt mutual fund schemes, which have defined maturity dates. These funds invest in Central or State Government bonds of certain maturities. They have a FD like structure, wherein they accrue the interest paid by these bonds and payout the accrued interest and principal on maturity. Since they are open ended funds, you can redeem units of target maturity funds at any time at prevailing Net Asset Values (NAVs). Target maturity funds are suitable in high interest environments like now, since you can lock-in the prevailing yields till maturity. As per current SEBI regulations target maturity funds can only invest in G-Secs and State Development Loans (SDLs), which have sovereign status and therefore, no credit risk. You should select target maturity funds depending on your investment needs.


• International equities: Index funds provide low cost opportunities to diversify your investments in international markets. There is low correlation of returns of different markets; adding international index funds can reduce your portfolio volatility e.g. some international markets may outperform when India underperforms. Investments in international equities can provide you exposure to global megatrends especially in areas of advanced technologies that are not yet mature in India. Additionally, you can benefit from INR depreciation. Your asset allocation in international equities will depend on your risk appetite and investment needs. You should consult with your financial advisor, if you need help in determining your asset allocation across different asset classes and which international market may be suitable for your investment needs.

Low cost (TER)

Total expense ratio (TER) of a mutual fund scheme is the cost of managing and operating the scheme on a per unit basis. It is calculated by dividing the total expenses of the fund with the assets under management (AUM). The expenses of the fund include fund management, registrar and transfer agent fees, custodian fees, transaction costs and marketing and distribution costs. TERs have a direct impact on returns because TERs are deducted from the market value of the underlying securities of the scheme portfolio to arrive the scheme’s Net Asset Values (NAVs).

While Total Expense ratios (TER) of index funds are much lower than actively managed mutual fund scheme, if there are two index funds tracking the same benchmark index, the fund with lower TER is likely to outperform the fund with the higher TER. Even if the difference in TERs is small, the difference in absolute returns over long investment horizons can be significant due to compounding effect.

Low tracking errors

Tracking error is the deviation of the index fund returns from the market benchmark index returns. Standard of monthly deviation of index fund and market benchmark index returns is defined as tracking error. There are various sources of tracking error e.g. fees and expenses of the scheme, cash balance held by the scheme due to dividends received, halt in trading on the stock exchange due to circuit filter rules, etc. You can find tracking errors of index funds in the monthly fund factsheets. You should always invest in index funds having low tracking errors.

Summary

Both active funds and index funds can play important roles in your portfolio. Your core and satellite portfolios can comprise of both active and index funds. Index funds can be cost effective and convenient investments to provide diversification to your investment portfolio. In this article we have discussed that there are many investment options in index funds. We have also discussed how to select index funds depending on your risk appetite, investment experience and investment needs. You should consult your financial advisor or mutual fund distributor about index funds that can be suitable for investment needs.