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“Why look for a needle in a haystack, when you can buy the entire haystack?”
That was The Vanguard Group founder Jack Bogle’s famous argument for indexing, nearly half a century ago, when he launched the first index fund for individual investors.
Index investing allows market participants to simply use a defined basket of stocks or securities to build an investment portfolio to meet their goals. The investment approach of index investing is easy to execute and offers instant diversification at a low fee.
The index investing approach follows the replication principle. This means purchasing every stock in an index at its given component weight to ensure that a portfolio will achieve the same risk and return profile as the underlying benchmark itself.
For instance, to replicate the Nifty 50 Index, an investor would need to buy the same 50 companies in the same proportion or weight that are part of the Nifty 50 Index. Further, the investor will also have to manage the periodic reconstitution/rebalancing of the index along with all the corporate action events of stocks like dividends, mergers, demergers, rights issues, etc happening at a stock level forming part of the index.
A simple alternative to this is to invest in passive funds offered under a mutual fund structure where the index replication and management are done professionally by a fund manager. An investor can invest in passive funds in two ways: through Index Funds or Exchange-Traded Funds (ETFs).
In the initial phase, index investing was only about considering the broad market indices like Nifty 50, S&P BSE Sensex, Nifty Next 50, etc. This was followed by sectoral/thematic indices like Nifty Bank, Nifty IT, Nifty Pharma, etc. And now it’s all about the smart beta of factor-based indices hitting the market.
The smart beta indices consider a broad market index as the parent index and select stocks based on certain factors like Momentum, Low Volatility and Value within the parent index, with the goal of beating the traditional broad market benchmark indices.
Warren Buffet once said, “A low-cost index fund is the most sensible equity investment for the great majority of investors.” And the reasons for that are:
- Convenience: Index funds contain hundreds of stocks that would be incredibly hard to replicate at an individual level
- Diversification: Holding a large array of stocks diversifies away idiosyncratic (firm-specific) risk
- Low cost: Because index funds take a passive approach to tracking an index, it has lower management fees than an actively managed fund
- Ease of Investment : Index investing is relatively easy compared to building your own portfolio
Once the power of index investing is established, it is also important to know how to start the index investing journey.
The first step to index investing is choosing the right index for your portfolio based on the return and risk profile.
Two common indices in the large cap segment are the Nifty 50 Index (an index composed of the 50 largest companies by market capitalisation listed on NSE) and the S&P BSE Sensex Index (a composite of the 30 largest companies by market capitalisation listed on BSE). For beginners, these large cap broad-based indices can be a good strategy to start their index investment journey. However, these indices are used generally across all categories of investors.
For individuals with more advanced financial knowledge, index investing can be a very useful tool to potentially “beat the broad market.” If you expect a particular sector like Nifty Bank , Nifty IT etc or factor such as Momentum, Quality to outperform, you can choose to invest in an index that represents such sector or factor.
For example, if you expect banks to outperform in the future, you may look into investing in Nifty Bank index. Further, each factor performs well at different points in the business cycle. If you feel confident of any specific factor, you can target it by buying into a factor indices like Nifty 200 Momentum 30, S&P BSE Low Volatility or Nifty 500 Value 50 Index.
Of course, it should be noted that investing in a specific sector or factor will increase your risk. Nevertheless, higher risk comes with a higher return, so if you bet on a specific sector or factor and that performs favourably, you can considerably beat the broad market.
The second step is to choose a fund (Index fund or ETF) that tracks such an index. Many Index Fund/ETF providers will have similar offerings with slight variations, so it is wise to research before considering a particular fund in the category. Such differences could be the experience of the provider, scale/size of the fund, track record in terms of tracking error and tracking difference and expense ratio, etc. Additionally, in the case of ETFs, the secondary market liquidity and the total cost of ownership should also be considered before investing.
Index funds can be a great addition to your portfolio for your long-term goals. In the short term, index funds can experience fluctuations but over a period of time they can generate attractive returns what with volatility risks being smoothened out.
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