Understanding Index Investing and its Pros and Cons

Index investing is a form of passive investing that involves buying and holding a portfolio of stocks that mirrors the constituents of a specific index with the aim to try and match the returns of that index, subject to tracking error. The fund manager of an index mutual fund creates a portfolio that has a proportionate representation of each security of the relevant index.

This is unlike active mutual funds, where fund managers handpick stocks and try to potentially outperform the market.

In this article, we will provide an overview of index investing and its benefits and disadvantages for an investor.

• Table of contents

1. Key features of index investing
2. Importance of tracking error
3. Popular Indian indices
4. FAQs

Key features of index investing

• Passive investment strategy: Index investing is a passive investment strategy that involves a “buy and hold” approach. The portfolio tracks the performance of specific index.
• Diversification: Index investing can provide exposure to different sectors and industries. This can potentially help to mitigate the risk associated with investing in a single stock or sector.
• Relatively low cost: Passive index funds have relatively lower expense ratios compared to actively managed mutual funds. This is because index funds don’t require active management, as the portfolio is designed to track the index performance.
• Tax-efficient: Capital gains from equity-oriented index funds may receive favourable taxation depending on the holding period. Investments held for more than a year are subject to long-term capital gains tax of 10% (as opposed to 15% short-term capital gains tax for a holding period of less than a year).

Importance of tracking error

Tracking error is a key metric in index investing. Tracking error is a measure of how much an index fund deviates from the performance of the underlying index. A higher tracking error implies a greater deviation from the benchmark returns. Tracking error thus helps gauge the performance of an index fund.

From an investor’s point of view, a lower tracking error is desirable as it indicates the ability of the fund to closely match the performance of the underlying benchmark.

Popular Indian indices

• Nifty 50: The Nifty 50 is a benchmark index that represents the performance of 50 of the largest and most liquid companies listed on the National Stock Exchange. It covers a wide range of sectors and is widely used as a benchmark for investment performance.
• S&P BSE Sensex: The Sensex is a benchmark index that represents the performance of 30 of the largest and most liquid companies listed on the Bombay Stock Exchange. It is widely followed by investors and financial media as a gauge of the Indian stock market's performance.
• Nifty Next 50: The Nifty Next 50 is an index that represents the performance of the next 50 largest and most liquid companies listed on NSE, after the Nifty 50. It provides a broader representation of the Indian stock market and can be a useful tool for investors looking to diversify their portfolio beyond the large-cap space.
• Nifty Bank: The Nifty Bank index tracks the performance of the banking sector in India. It includes the largest and most liquid banking stocks listed on the NSE.
• BSE Midcap: This represents the performance of the mid-sized companies listed on the BSE.
• Nifty Smallcap: The NSE Smallcap indices represent the performance of the small companies (by market capitalisation) listed on the NSE.

Pros

• Enables easy diversification through one investment.
• Has a lower expense ratio than actively managed funds.
• Can be appealing to new investors who would rather diversify through one investment than through a basket of mutual funds.

Cons

• The fund does not aim to outperform the benchmark index, which may, in some market conditions, reduce return potential.
• Fewer choices for investors as compared to active mutual funds.

FAQs

What are index funds?
Index funds are pooled investment vehicles that aim to replicate the performance of a specific market index. They offer investors exposure to a diversified portfolio of stocks or other assets.

What is an investment index?
An investment index, also known as a market index, tracks the performance of specific assets like stocks or bonds, serving as a benchmark for market performance.

What is index investing?
Index investing is a passive strategy where investors aim to replicate the performance of market indices, such as the S&P BSE 500 or the Nifty 50, rather than selecting individual stocks to beat the broader market.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.