Long Term Investing with Index Funds

Published On: 06-Oct-2020

Index funds are a type of funds, which aim to replicate a particular index. The fund manager does not have any individual discretion to make changes in the portfolio changes, and the portfolio can be changed only to align it with the changes in the underlying index. 

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Since the market indices are constructed through a robust index construction methodology, taking into consideration various relevant parameters, it is obvious for the investors to have an investment exposure directly into such indices. However, since the indices are not stock or security in themselves, investors need to construct a portfolio with same securities and similar weights to replicate the index returns. Alternatively, investing in index funds can help investors achieve the same objective. 

Being a passively managed investment product, such funds tend to have a lower Total Expense Ratio (TER) as compared to actively managed funds. Since the expense ratio eats into portfolio returns, a lower expense ratio directly translates into higher returns for the investors. Here is how a lower expense ratio and consequently, higher returns may make a big difference for the investors over the long term:

Particulars

Actively Managed Funds

Index Funds

Monthly Investment

Rs. 20,000

Rs. 20,000

Time Period

30 years

30 years

Assumed Portfolio Returns

16%

16%

Assumed Total Expense Ratio (TER)

1.30%

0.30%

Scheme Returns 

14.70%

15.70%

Amount Invested 

Rs. 72 lakhs

Rs. 72 lakhs

Portfolio Value 

Rs. 13.07 crore

Rs. 16.53 crore

 

 * Assumed portfolio returns based on CAGR returns of S&P BSE Sensex since inception (December 1978 to December 2019)

As illustrated in the table above, the investor would have invested Rs. 20,000 per month over 30 years and would have invested Rs. 72 lakhs in aggregate. However, due to lower TER, the returns may be higher, based on assumed portfolio returns. A difference in returns by even 1% has the potential to impact the portfolio by around Rs. 3.5 crores over 30 years, which is around five times the principal investment. 

Further, index funds also help the investors in pursuit of portfolio diversification as index funds replicate the benchmark indices, carefully constructed based on various eligibility parameters. As such, investors may have a diversified exposure to multiple companies and market segments. Since the index is intended to fairly represent the overall market sentiments, investing in index funds may provide an equivalent investment exposure with a single investment.

When making an investment decision, it is crucial to understand the risks associated with the investment. The investments are mainly exposed to two types of risks – systematic risk and unsystematic risk. Systematic risk refers to the risks associated with the changes in the macroeconomic scenario, which may impact the portfolio securities. 

On the other hand, unsystematic risk refers to the risk of making the wrong investment call, which may result in lower investment returns. The index funds help in the elimination of unsystematic risk for the investors, as the fund manager may not take any specific investment calls and may only maintain the index weight in the same stocks. So, the overall investment risk gets mitigated for the investors to a certain extent. 

As such, index funds may be considered by the investors if they are looking for investment exposure in equity markets at a relatively cheaper cost. The investors may invest in index funds to replicate the returns of the underlying index and aim for wealth creation over the long term. 

 Disclaimer: The chart/information shared above is for illustrative purposes only and should not be construed as advise. The above is to illustrate the concept of asset allocation. There is also a possibility of the expected event not happening or some other unforeseen event that may affect the future performance of asset class. Investors are requested to note that there are various factors domestic and global that may have impact on performance of the asset class mentioned in the article. Information given is available in public domai