What are Index Funds? Is it recommended to invest in them?

Q: Hi, I was wondering if Goalwise recommendations include Index funds? I have been considering to gradually shift the equity portion of my portfolio from managed funds to Index funds. Do you have any thoughts?

What are Index Funds?

Index funds are a type of Mutual Fund only.

The difference is that while non-index funds aim to beat their benchmark by active selection of stocks based on the fund manager's strategy (hence also called 'active' funds), Index funds aim to merely replicate their benchmark by holding the same stocks (and in the same proportion) as the benchmark (hence also called 'passive' funds).

For eg HDFC Sensex Index Fund will always invest in the same stocks as present in Sensex (in the same proportion). There is no active stock selection by the fund manager and the returns will match Sensex returns (and not exceed it).

Significance of Index Funds

Index funds (and their ETF counterparts) are more popular in developed markets like US etc where the markets are quite efficient thus making it difficult for active Mutual Fund managers to beat them over the long term.

In this situation, investing in (and updating) active Mutual Funds becomes an un-necessary exercise (as they dont end up beating the index generally over the long term) and investors prefer to just invest in Index Funds.

In India however, because the markets are still developing, many actively managed funds perform better than their benchmarks (hence better than index funds), so it makes more sense to invest in active funds rather than Index funds in general.

Our Recommendations

However, even in India in the large cap space, funds are finding it increasingly difficult to beat Nifty or Sensex.

So this year in our list of recomemnded funds, we have added one index fund (HDFC Sensex Index Fund) in the large cap category.

But in other categories like Multicap/Mid Cap/Small Cap, we believe we still have several years to go before the opportunities for active stock selection and management dry up. So we would continue recommending active Multicap Funds rather than going for Index funds in this space till they keep outperforming their benchmarks.

And in future, as we follow a data driven Mutual Fund selection strategy, we may include more index funds in our recommendations as and when they become as good as actively managed funds in terms of net returns.