How Index Funds Offer Simple Wealth Building for Indians

Not everyone has the time, interest or expertise to study balance sheets, and that is perfectly acceptable. For such investors, passive investing provides a straightforward alternative. When a trader reads about the Kospi Index in a market bulletin, it is a reminder that benchmarks are used everywhere to measure and replicate market returns. Closer to home, funds that mirror the Sensex Index allow ordinary savers to own a slice of India’s largest companies with a modest monthly contribution. This approach has gained popularity because it is transparent, inexpensive and easy to follow.

The Logic Behind Passive Investing

An index fund tracks a benchmark. It buys the same shares in the same proportions as that of a particular index. Since it does not attempt to beat the market, the decisions tend to be rule-based

Studies across different markets reveal that a significant chunk of active funds fail to outperform the benchmark consistently

While there may be some funds that do beat the market consistently, it is hard to identify such funds beforehand

With passive funds, you are guaranteed to get a market-like return, less a small expense. Here is how to go about it:

Low Costs Matter

The most important differentiator tends to be the expense ratio. Even a one per cent difference can have an adverse impact on your returns over a twenty-five-year period. Funds that are directly purchased (direct plans) tend to have lower expense ratios. Apart from the expense ratio, check the tracking difference, which is the difference between the returns of the fund and the index it tracks. The lower it is, the better. Finally, compare the expense ratio, tracking difference and size of different funds.

Tax and Liquidity

Since mutual funds are a fairly liquid asset, buying or selling units is simple. The taxation depends on the fund and how long the units are held. It is better to hold on to units for a longer period as the tax liability reduces. The mutual fund industry keeps changing, so it is best to check the most recent tax rules or get in touch with a tax expert.

Index funds are also good in terms of taxation as they have a low turnover ratio. If you rebalance only once a year, the tax liability would be minimal.

Core and Satellite

A popular approach among investors is to use the core and satellite strategy. Here, an index fund comprises the core, say seventy to eighty per cent of the total equity allocation. The rest can be split between individual stock picks and other thematic funds. This approach ensures that you make a market-like return on most of your money while letting you experiment with the rest.

Diversify your index funds as well. While a large-cap index fund is a must, you can also look at mid-cap or small-cap funds to get exposure to faster-growing companies. Debt funds, gold and real estate are also good ways to diversify.

Staying the Course

The easiest thing to do while investing in index funds is to stay put. In fact, the only way to make index funds work is to stay invested for the long term. The most difficult part is to stay invested, especially during market corrections or bearish cycles. Those who stayed invested during the recent market crash are likely to have recovered most of their losses as the markets have rallied since then. Set up systematic investment plans to ensure that you stay invested. Increase the quantum of your SIPs every year as you get a higher salary. This is called a step-up option. Stick to the allocation and do not get fazed by market movements. Only rebalance if equities have moved significantly beyond the stipulated limit.

Index funds are boring. But boring funds are great because they let you sleep at night. You get the market return (minus expenses) and do not have to worry about too many parameters. For a working family, investing in index funds can be the ideal way to build a corpus towards children’s education, housing loans or retirement.