7 Reasons to Invest in Index Funds
Index funds are a very interesting investment product.
I like index funds because they are simple.
Here are 7 reasons to invest in an index fund.
1) It is low cost.
An index fund is not something which is managed by a fund manager.
It's like a system that has been set to track a particular index.
It's like a machine.
Since it is completely automated, it is low cost.
And the lower the cost, the better are the returns for the investor.
The fund management expense is very low.
2) It is easy to understand.
There is nothing complicated about investing in an index fund.
Example: if there is an index fund that is tracking the Nifty 50, which comprises the top 50 companies in India, then basically, the fund is investing in the top 50 companies in India, in the same proportion, as they are in the index.
It is as simple as that.
The investor always remains invested in the top 50 companies in India.
So, if one of the companies falls off the index, some other company replaces it.
Essentially, the investor remains in the top 50 companies.
3) It has relatively low risk.
The reason why I say, 'relatively low risk' is because, yes, it is a bit risky.
If you are investing in an equity index fund, you are taking the risk of the markets going up and down.
Even the index can go down 50%, sometimes in a year or two.
However, the risk is 'relatively low'.
One reason I just explained to you.
Example: I invest in an index fund. One of the companies, gets removed from the index. But then there is this other better company that comes into the index.
That way, my risk goes down.
4) Zero human error.
As I said earlier, an index fund is something which is not managed by a fund manager.
If I am a fund manager, I am taking a view on the future.
And my view on the future can be wrong.
Sometimes, it can be right as well.
But chances are always there that, my view might go wrong.
Those chances are not there in an index fund, because it is not managed by a fund manager.
It is simply tracking an index.
There is zero human error.
One fund manager might have an optimistic view of the future.
Another fund manager might have a pessimistic view of the future.
One of them may be right, one of them may be wrong.
Who knows what is going to happen in the future.
In an index fund, I at least know that, I am taking a bet on the top 50 or 30 companies through that particular index.
I am not worried about what people feel about the future.
5) It saves time.
This is very important.
If I am an investor and I want to invest in a particular company, I will have to study its balance sheet, I will have to study the management of the company, I will have to study the industry, the competition, the products, the business, the services.
I will have to look at a lot of variables to come to a reasonable conclusion that, this company is worth investing, at that particular price.
And this research takes a lot of time.
Whereas in an index fund, I don't have to do all of this research.
I just take a bet on a particular market in a particular country and that's it.
I simply invest in a Sensex or a Nifty and I am done.
I don't have to do any thinking, since it's a passively managed fund.
I don't even need to monitor it, as long as it is a certain percentage of my portfolio.
It saves a lot of time for me.
I can carry on with my business or whatever profession I am in and let the index fund take care of my investments.
6) It is good for non-finance people.
I am a finance guy.
So, I can read balance sheets and profit & loss accounts and cash flow statements.
Think about someone who has never studied finance, has no formal education in finance, somebody who is an arts graduate: what does he know about balance sheets?
Index funds simplify everything.
It makes it easy for the even the layman to invest in equities.
It provides you reasonable diversification as well, plus it is low cost.
What else can we expect from a particular fund.
It has far lower risk compared to direct ownership of equities.
7) It is better than actively managed funds.
In the US, they have done a lot of research.
In that research, they found out that, over long periods of time, it is index funds that outperform the actively managed funds, because as we discussed earlier, in actively managed funds, there is this human error involved, or there is this human bias involved, which is not there in index funds.
So, it's very difficult, as markets mature, to beat the indices.
So over the long period of time (when I say a long, I am talking 10, 15, 20, 30 years), it is index funds that have given better returns.
So, would it not make sense to invest in index funds?
What else is a better alternative to a non-finance person?
Important Note: It makes sense to invest in a staggered way (Example: small amount going in, weekly or monthly). The risk with ad-hoc one-time investment in an index fund is that, you might end up putting a chunk of your money at the top of the market.
Don't make that foolish mistake.
Rohit Musale, CFA
19 December 2022