Index fund

Why Index funds?

 " A low-cost index fund is the most sensible equity investment for the great majority of investors." - Warren Buffett

"The two greatest enemies of the equity fund investor are expenses and emotions."

-Jack Bogle

"On average, the average large-stock fund manager produces average returns before fees and below-average returns after fees. So compared with after-fee returns, an index fund is superior."

-Howard Marks

I am 18 and have no experience in picking stocks nor do I have the knowledge but for me to get astounding returns for my investments the best thing to do is start early. So that leaves me with two options either invest in a low-cost index fund or invest in a mutual fund.

Importance of starting early

What is an Index fund?

An index fund is simply put an aggregate of the top 30,50,100 or more companies in the market. For example, the Nifty 50 index tracks the top 50 companies on the NSE. It acts as a benchmark for how the market is doing. Some indices track market sectors as well. Now you cannot invest in the index but you can invest in an index fund which is basically just a mutual fund which tracks the index. 

What is a Mutual fund?

A Mutual fund is a company that you hire to invest your money for you and charge a commission for their expertise in picking the stocks they invest in. They also have options for investing in index funds where they do not have to do any research as they just buy the companies in the index for you. There are various types of mutual funds such as large-cap funds, Flexi cap funds, Small-cap funds, etc.

5-year returns and expense ratios of top 5 Index funds

Comparing this to the top 5 Flexi cap mutual funds over 5 years which do not have a restriction of investing in companies based on market capitalization. ( Source: www.moneycontrol.com )

1. Parag Parikh Flexi cap             - 18.64%
2. Quant Flexi cap                        - 17.90%
3. PGIM India Flexi cap fund      -16.16%
4. UTI Flexi cap fund                   - 15.01%
5. Canara Robeco Flexi-cap fund -14.81%

The expense ratio of these firms is around 1-2% Assets Under Management (AUM). When you factor this in only five funds beat the benchmark index out of around 30 Flexi cap funds. The NSE500 is at 12.39%. (The benchmark index in this case)

So to sum up the differences between the two:

                                                               Index funds:

• Cost: Index funds are relatively low cost as they do not need the expertise of professionals to pick the stocks to invest in. The expense ratio is under 1% and around 0.5%.
• Performance: Index funds cannot outperform the index benchmark although it does underperform if you weigh in the expenses which are around 0.5% on average so you underperform but not by a lot.
• Risk: Index funds are not too risky. 

Mutual funds:

• Cost: Mutual funds usually charge a higher commission as they hire fund managers who pick stocks which require time, effort and money. The expense ratio is usually above 1% and goes up to 2% for some funds as well.
• Performance: The main aim of Mutual funds is to beat these indexes and generate a higher return for their clients but sometimes a fund can also underperform the index. (Case with a lot of funds). It is not easy to generate above-average returns even for professionals.
• Risk: Mutual funds are riskier as there are stocks picked by the people who manage the money. Also, you have to do more research on mutual funds as very few mutual funds outperform the benchmark index.

Who Should Invest in Index Mutual Funds?

Those who prefer long-term investing: Index funds could be risky for the short term but over time such funds have the potential to beat the market index.

Those who want to invest passively– Index funds are passively managed funds low-cost funds that have lower expense ratios than actively managed funds.

Those who want to diversify– Index funds are known to be key when it comes to portfolio diversification. You can spread your investments across different types of assets and securities to balance out or mitigate the risk.

Important things that differentiate Index funds' returns.

• Expense ratio: Index funds have different expense ratios, some funds have high expense ratios causing the clients to get lower returns.
• Tracking ability: Some Index funds make a few errors in tracking the index properly which causes them to underperform the benchmark without expenses also
• Customer service: Index funds might be differentiated based on customer experience some funds might provide better services than others.