Index funds are the simplest, easiest, no-fuss investments to build wealth over time. Instead of picking out stocks individually, index funds present a unique opportunity to indirectly buy the whole market. Individual stocks may rise and fall, but indexes tend to rise over time. You are therefore minimizing your risks when you invest in an index fund. Index funds are slightly different from ETFs as they don’t require a Demat account and a stockbroking account
What is the profile of an index fund investor?
Investment decisions depend upon risk profiles and investment goals. Overall, index funds are a perfect option for:
- Investors with low-risk appetite seeking equity exposure.
- Investors with a long-term investment horizon.
- Someone who wants to invest in equities but does not want to track performance.
One should not invest in Index Funds if;
- You are an investor seeking outperformance vis-a-vis the index
- If you have a short-term view and require funds in the short-term.
- If your risk profile indicates that an aggressive approach to investing is more suited to you
How to create an optimum investment strategy using index funds?
As an individual, it is prudent to follow a three-step approach to manage your money with a limited commitment of time and market data resources;
- Identify specific financial goals like a new car, children’s education, retirement, etc.
- Create an asset allocation and timeline for each goal
- Invest regularly with an aim to achieve your goals
For step 3, financial advisors often suggest using index funds as a complementary strategy for gaining the requisite equity allocation. They call it a CORE and SATELLITE approach.
The core portion of the portfolio forms a major part of the portfolio that has the ability to create long-term value for the investor.
- Aims to provide market-based returns.
- No fund manager style bias as different styles perform in different market periods.
- Can be useful especially in the large-cap segment.
The Core could be a combination of index funds on Nifty 50 and Nifty Next 50. This provides exposure to the large-cap universe comprising good companies, which are leaders in their sectors and have seen multiple business cycles. So your Core allocation now has a diversified and transparent portfolio of such companies via just two low-cost index funds.
The satellite portion of the portfolio aims to create returns over and above the market. This portion
- Can have the potential to generate alpha.
- Different funds with different fund management styles (e.g. small-cap, mid-cap, value etc.)
- Short term tactical allocation for seeking better returns can be done.
For the Satellite allocation, use active funds managed with a robust process and investment framework, which provide the potential to generate outperformance over the benchmark. The Satellite could also include other investment classes such as gold, sector funds, international funds, etc., some of which might be for a relatively shorter period of time for tactical market views. So your Satellite allocation has a differentiated allocation, often needing a bit more analysis and research before investing.
The most important financial goals are usually common – for most of us, they are aligned to the happiness of the family, a better life for children, starting or expanding a business/profession. Some of us often get preoccupied with the wrong priorities – like increasing returns at all costs or finding the next star fund manager. Instead, a better approach could be to keep it simple by investing in a low-cost index fund giving exposure to the broader market, with an aim to achieve your goals with a reasonable degree of certainty
You cannot directly invest in Index as they are only mathematical constructs! Therefore, Index funds.
ANIL GHELANI, CFA
Head of Passive Investments & Products
DSP Investment Managers
Anil has been working with DSP Group since 2003. He is currently Head of Passive Investments & Products. Previously, he served as the Business Head & Chief Investment Officer at DSP Pension Fund Managers. Earlier in his career at DSP, he led the Risk and Quantitative Analysis team providing quantitative research inputs and buy-side credit research on companies across various sectors.
He has been a volunteer with the CFA Society India for more than a decade and currently serves as the Vice-Chairman on the board.