They are okay to start with, but can't be your core investment over time
Clearly, these funds are for investors who want the upside of equities without taking much risk. Index funds provide security to the equity side in the portfolio, as it moves according to a broader index. But remember these are also equity funds. So, in case of sharp market downturns, these funds will also be affected.
An index fund follows a passive strategy, instead of picking individual stocks. Their portfolio constitutes the same stocks, in the same ratio, as in the broader index. So, you know where is your money invested, without any nasty surprises.
These funds employ a buy and sell strategy based on movement of the index and do not incur trading costs and analysts' fees. As a result, their annual fund management fee is 1-1.5 per cent, as against the 2.25 per cent charged by equity diversified funds.
Templating the broader indices also helps diversify and lower volatility in comparison to single stocks or even sectors, making it a safe scheme to invest.
However, since these funds mirror the index, they are never be able to outperform the broader indices like equity diversified funds. In the past year, index funds have returned anywhere between 15 and 60 per cent. Nifty Junior BeES has given 40.08 per cent against Nifty's 22.76 per cent. Nifty Benchmark ETS has returned 23.58 and LIC MF Index Nifty 22.87 per cent, according to data from Value Research. In comparison, equity diversified funds returned 29.95 per cent.
Experts say new investors can begin with index funds. However, over the long term, these funds should not form a large part of the overall portfolio. Around 20-25 per cent of the exposure is recommended. This is because investing solely in these funds will deprive the investors of earning the higher returns generated by mid-cap and small-cap companies.
Typically, freshers can start with index funds and move to large-cap ones. As you gain experience, take 5-10 per cent exposure in mid-cap funds. Later, you can buy sectoral /thematic funds.
Index funds are a good option in bad market conditions, when the fee levied by a fund house eats into the low returns. Their biggest drawback is the tracking error, the difference between the returns of the underlying index and the scheme. Internationally, tracking error is less than two per cent, but it is much more here. Many schemes have returned five per cent, some even 10 per cent lower returns than the underlying indices in the past year. As a result, most funds have underperformed their indices by a big difference.
KEY TO MARKET
Safe and offers diversification, as it mirrors broader index
Cheaper than actively managed funds
New investors could start with index funds
Overall portfolio should have 20-25 per cent exposure
Biggest drawback is tracking error