Index investing has become a buzzword in India. More and more investors are using this strategy to build their investment portfolios.
The origins of index investing trace back to the 1970s, when a group of academics and investors began to challenge the conventional wisdom of actively managing a portfolio or active investing.
They argued that it was nearly impossible for investors to consistently beat the market by selecting individual stocks. Most investors would be better off buying a diversified portfolio of stocks that mirrored the overall market’s performance.
John Bogle launched the first index fund, the Vanguard 500 Index Fund, in 1975. The fund tracked the performance of the S&P 500, a US stock index.
Read on as we’ll provide a detailed overview of index investing, how it works, and why it’s an intelligent choice for investors.
What Is Index Investing?
Index investing is an investment strategy that involves investing in a stock market index, such as the Nifty 50 or the NASDAQ.
A stock market index measures the performance of a group of stocks selected and weighted according to a particular methodology. Stock indices track the performance of specific stock market segments, such as large-cap stocks or a particular sector.
- The Nifty 50 is a widely followed stock index that tracks the performance of 50 large-cap Indian stocks.
- Nifty Bank Index is a benchmark index that tracks the performance of the banking sector listed on the National Stock Exchange (NSE). It includes 12 banking stocks, including the State Bank of India, HDFC Bank, ICICI Bank, and Axis Bank.
Index investing is also called ‘passive investing.’
Now you might wonder if there is something called active investing. Yes.
Active investing is the process of actively picking individual stocks or actively managing a portfolio.
Active vs. passive investing
One of the main differences between passive and active investing is the level of involvement from the investors.
- Active investors try to beat the market by picking individual stocks and timing the market. This approach can be risky and time-consuming. Also, it’s difficult to outperform the market consistently.
- On the other hand, passive investors aim to match the market’s performance. It invests in a diversified portfolio of stocks that mirror a specific index. Thus, it requires minimal investor intervention.
Numerous studies have shown that index funds outperform most actively managed funds over time in developed markets such as the United States. But, the Indian mutual fund industry is relatively new, and many actively managed funds have outperformed the market over the past few years.
That said, active funds in India generally have higher fees and expenses than index funds. Also, active funds are subject to manager risk, where the fund’s performance highly depends on the fund manager’s decisions.
Overall, index investing has democratized investing. It allows ordinary investors to gain exposure to the financial market and build long-term wealth.
How Index Investing Works
Index funds work by tracking the performance of a specific index.
The fund manager buys shares of the companies that make up the index in the same proportion as the index. It helps the fund mimic the index’s performance.
Index funds typically have lower fees than active ones. This is because they don’t require a team of analysts and portfolio managers to make investment decisions.
In index investing, market capitalization is often used to weigh individual stocks within the index fund. Market capitalization is a measure of a company’s value. It is calculated by multiplying its share price by the number of shares outstanding.
Companies with a larger market cap will make up a higher % of the fund. This helps ensure that the fund mirrors the overall market’s performance.
Index investing is generally considered a low-risk investment strategy. But it’s important to understand that risk is still involved.
Stock prices can be volatile, and the market can experience significant fluctuations in the short term. But, by investing in a diversified index fund, investors can reduce their exposure to individual stock risk and market risk. Diversification helps offset losses in one sector with gains in another, which can help manage risk effectively.
Index investing also aligns with the ‘buy-and-hold’ investment philosophy. It involves buying and holding investments for an extended period of time. Thus, index funds are an excellent choice for long-term investors as they offer consistent returns over time.
Index funds can be either closed-end or open-ended. Closed-end funds are bought and sold at the end of each trading day. Open-ended funds or Exchange Traded Funds (ETFs) can be traded throughout the day, like individual stocks.
Benefits of Index Investing
There are several benefits to index investing.
1. Low Cost
Index funds are passively managed; they typically have lower fees than active funds.
Index funds invest in a broad range of stocks. It helps to reduce the risk of losses due to the poor performance of a single stock.
3. Long-Term Growth
Index investing is a long-term strategy that aims to capture the market’s returns over time.
Index funds are highly transparent. It means investors can easily see the fund’s stocks and their performance.
5. Ease of Use
Index investing is simple and requires minimal intervention from investors.
Index investing is a low-cost and effective investment strategy.
Over the years, it has grown in popularity worldwide, with trillions of dollars now invested in it. The success of index investing can be attributed to its simplicity, low fees, and consistent returns over time.
In India, the Assets under management (AUM) of Index Funds (both open and closed-end) tracking the Nifty 50 index is over INR 2 Trillion.
It is a smart choice for investors looking to build long-term wealth. Thus, by understanding how index investing works, investors can make informed decisions and achieve their financial goals.
1. What is the difference between index funds and mutual funds?
Index funds and mutual funds are both investment vehicles that pool money from many investors to purchase a portfolio of securities.
But index funds are passively managed, while mutual funds are actively managed.
Index funds aim to replicate the performance of a specific stock market index. In contrast, mutual funds rely on a fund manager to make investment decisions.
2. What are the benefits of index investing?
Index investing offers several benefits — lower fees, broad diversification, and consistent returns.
Index funds have lower expense ratios than active funds, making them cost-effective options. It also exposes investors to a broad range of stocks and industries, which helps manage risk and optimize returns.
3. Are there any downsides to index investing?
While index investing offers many benefits, there are some downsides to consider.
- Index funds may underperform active funds, especially in low-mature markets like India.
- Also, investors in index funds are subject to market risk and are not protected against losses during market downturns.