Index investing - New smarter way of investing
Sensex has grown from a base value of 100 in the year 1979 to around 50,000 today. Isn’t it surprising, that to grow your money by 500 times in 42 years, at 16 per cent CAGR, all you had to do was buying and holding the index?
Varun Malhotra, Director & Founder, Edge Institute for Financial Studies (EIFS) is of the view that for a know-nothing investor, the simplest way to participate in India’s growth story is to bet on the growth of the Indian economy, and one of the best ways to do that is to buy index funds that replicate the performance of benchmark indices like Sensex, Nifty, or Nifty/BSE 500. This is known as ‘index investing’.
What are the advantages of investing in an index fund?
Low cost: The expense ratio of Nifty Index Fund Direct Plan is as low as 0.05-0.1 per cent per annum. On the contrary, if you buy a regular plan of an actively managed mutual fund, you might end up paying more than 1.5 per cent per annum to the fund house and the distributor. It is important for investors to realise the effect of a high expense ratio on their investment in the long run. If you invest Rs 12,000 every year for 40 years at a rate of 15 per cent p.a., you will accumulate Rs 2.1 crore whereas, the same amount invested for the same period at 13.6 per cent p.a. (assuming the expense ratio index funds to be 1.4 per cent lower) would result in a corpus of Rs 1.43 crore.
By investing in an index, even a know-nothing investor can beat most of the actively managed mutual funds. One of Warren Buffett’s quotes in favour of index funds says it all, "By periodically investing in an index fund, the know-nothing investors can actually outperform most investment professionals.” To understand what Warren Buffett means, let us look at the historical performance of Nifty Fund/ETF as compared to other mutual funds. As of March 25, 2021, Nifty BeES, one of the oldest funds that replicate Nifty index, ranked 21st out of 112 funds, 20th out of 92 funds, and 21st out of 53 funds in the last 1, 3 & 10 years, respectively. (Source: valueresearchonline.com)
Buying an index fund helps you avoid a disaster i.e., buying the worst mutual fund that destroys your wealth. The secret to wealth creation can be understood by Warren Buffett's quote, "Ben Graham taught me 45 years ago that in investing, it is not necessary to do extraordinary things to get extraordinary results." All you have to do is avoid a disaster. Even if you manage to get average returns, the power of compounding will help you accumulate extraordinary wealth in the long-term.
However, the big question is, even though the historical data for index funds look good, will they be able to deliver higher returns in the future as well?
Investors need to realise that when they invest in indices like Nifty, Sensex, or Nifty 500, they are indirectly investing in some of the best and biggest companies of India today. It is also interesting to note that even though some of the companies that ruled the indices in the past like Hindustan Motors, HMT went out of business, the index kept on going higher, why? Because the weights of companies, which didn’t do well, reduced and were finally replaced by other better-performing companies. The index is a dynamic basket of the biggest companies in India and index funds will continuously make these changes in their portfolio as their job is to replicate the index.
So, when you invest in an index, you don’t have to worry about which companies will rule the Indian economy in the coming decades as long as the Indian economy does well.
However, investors should not forget that index investing will be as volatile as the market or the index. So, like all other equity mutual funds, know-nothing investors should invest in index funds using a systematic investment plan (SIP) and should always remember to not use index funds for their short-term goals.