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How to choose index funds

Maulik Tewari |BL Research Bureau | Updated on: Feb 19, 2022

Businessman looking at road with maze and solution concept | Photo Credit: ra2studio

While funds mirroring certain largecap and strategy indices may be good to hold, passive investing does not work for smallcap funds

Index funds have gained much in popularity in recent years. From under Rs. 8,000 crores of assets two years ago, they now manage close to Rs. 50,000 crores, and counting.

The buoyant stock market, combined with investor dissatisfaction with the underperformance of actively managed large cap funds has steered investor money into cost-effective index funds.

An index fund invests in the constituents of a particular index – equity or debt – with the aim of mimicking its returns. This is done at a lower cost than an active fund, which aims to outperform an index.

Today, there are over 50 equity index funds tracking diverse indices – ranging from large cap and small cap to momentum and quality. Are index funds worth investing in? Here are some insights to help you decide.

Large cap index funds

Large cap index funds are appealing because the vast majority of active large cap funds fail to outperform their benchmark index. This has been particularly so after SEBI’s 2018 recategorization exercise. Today, there is a wide range of large cap index funds from which to pick.

Investors can choose from four options – index funds tracking the Nifty 50 TRI, the Nifty Next 50 TRI, the Nifty 100 TRI, and the S&P BSE Sensex TRI.

Nifty and Sensex: The Nifty 50 TRI and the Sensex TRI, which represent the top large cap companies listed on the NSE and the BSE, respectively, have on average, delivered roughly similar returns across different investment periods over the last 10 years (see first table). The percentage of negative returns have been equally similar. So you can pick an index fund tracking either of these two indices for large cap exposure in your portfolio.

Go for an index with a relatively lower expense ratio. Another important indicator is the tracking error (TE), which provides an indication of how closely an index fund is tracking its index. The lower the TE, the better it is. However, given that the TEs for most large cap index funds fall within a narrow range of 0.10 – 0.27 per cent, it is hardly the differentiating factor here. Large caps represent the most liquid segment of the stock market, making it easier for funds to closely replicate the index with minimal impact cost.

The IDFC Nifty Fund and the ICICI Pru Nifty Index Fund, with expense ratios of 0.08 per cent and 0.17 per cent respectively under their direct plans are good picks. Two other options are the ICICI Pru Sensex Index Fund and the Nippon India Index Fund – Sensex Plan that charge expense ratios of 0.16 per cent and 0.15 per cent, respectively. All these funds have TEs of under 0.16 per cent and a long track record. Only funds with at least 3 years’ history have been considered for our analysis.

Nifty 100: While the Nifty 100 TRI represents a good investment, index funds tracking this large cap index have only recently been launched by AMCs such as Axis MF and IDFC MF – so they don’t have much of a performance record for investors to consider.

The Nifty 100 comprises the largest 100 companies (large caps) and is well-diversified across sectors. It accounts for 70 per cent of NSE’s total market capitalization. The returns from this index are not very different from those of the Nifty 50 and the Sensex (see first table).

In the absence of a track record, investors can wait to invest in a Nifty 100 TRI index fund. But, as the index comprises the most liquid listed stocks, a passive fund linked to this index should be able to deliver returns matching those of the index.

Nifty Next 50: The Nifty Next 50 consists of the 51 st to 100 th largest companies and represents 14 per cent of the NSE’s total market cap. While it comprises large cap stocks, its volatile nature means that the index cannot serve the role of a relatively stable large cap portion in your portfolio. Data shows that the superior returns of the Nifty Next 50 compared to say, the Nifty 50 or the Nifty 100 have been accompanied by higher volatility (see first table). This makes the index suitable only for long-term high-risk investors who want to boost their overall returns.

The Nifty Next 50 index funds from ICICI Prudential MF and UTI MF, are good options. Their TE of around 0.14 per cent is a tad lower than that of the other Nifty Next 50 index funds considered. The two funds charge expense ratios of 0.30 per cent and 0.33 per cent, respectively, under their direct plans.

Its’ worth noting that, while it may seem obvious to invest in a Nifty 100 index fund instead of making a 50:50 investment in a Nifty 50 and a Nifty Next 50 index fund, it may not lead to the same result. The Nifty 100 contains the Nifty 50 and the Nifty Next 50 companies put together, but their weights in the combined index are very different. The Nifty 100 is a market cap weighted index – this means that the significantly larger Nifty 50 companies get a higher total weight in the index making it overwhelmingly like the Nifty 50 itself. A Nifty 100 index fund will, therefore, work as a more diversified substitute for a Nifty 50 index fund.

Mid and Small cap index funds

High risk investors interested in passive exposure to midcaps have four index funds, all of which track the Nifty Midcap 150 TRI, to choose from. With all active midcap funds, except the Axis Midcap Fund, failing to outperform the Nifty Midcap 150 TRI – based on 3-year and 5-year rolling returns in the last 7 years, along with having higher instances of negative returns than the index, the case for midcap index funds is strong (see second table). However, none of the existing midcap index funds have a long performance record – three were launched in 2021 while the oldest, from Motilal Oswal MF, was launched in September 2019. Investors therefore need to wait and watch.

Similarly, small cap index funds too, have only a limited history. The oldest, from the Motilal Oswal MF stable, was launched only in September 2019. All three of the available funds track the Nifty Smallcap 250 TRI. With many small cap stocks facing liquidity issues, taking positions in these stocks to consistently mirror the small cap index composition may not be easy. More to the point, even assuming the funds match the index returns, the Nifty Smallcap 250 Index may not be the best way to get small cap exposure.

Many actively managed small cap funds are doing a good job of navigating the small cap space – with higher returns and relatively less volatility (see second table). Investors with a high-risk appetite are better off going active rather than passive here. Small cap funds from SBI MF, Axis MF, and Nippon India MF are the top performers.

Strategy index funds

Strategy indices use a strategy or a factor such as momentum, quality or low volatility, by applying quantitative parameters to a broader index. Take for example, the Nifty200 Momentum 30 Index which tracks the performance of the top 30 companies in the Nifty 200 based on their normalised momentum score. Or the Nifty 100 Low Volatility 30 Index that tracks the performance of 30 stocks in the Nifty 100 with the lowest volatility in the past year.

Likewise, the equal-weight versions of the Nifty 50 and the Nifty 100 indices provide an alternative weighting strategy, that is, of assigning equal weighs, instead of the market capitalization-based weighting of these indices. The equal weight indices have a less concentrated sector exposure than the market cap weighted indices.

Investors can use some of these indices to get exposure to specific factors, in addition to their core allocation to large cap indices.

Nifty200 Momentum 30 Index:

A momentum strategy relies on stocks that have done well in the recent past to continue outperforming and vice versa. Such a strategy assigns higher weights to outperforming stocks and sectors, and vice versa. The Nifty 200 Momentum 30 Index selects the top 30 high momentum large and mid-cap stocks from the Nifty 200 based on their last 6-month and 12-month price return after adjusting for daily volatility. Each stock is weighted based on its free float market cap multiplied by its momentum score subject to a 5 per cent cap.

Data shows that the Nifty 200 Momentum 30 Index has delivered 3-year and 5-year rolling returns (CAGR) of 16 per cent and 17 per cent, outperforming its parent index returns of 10 per cent and 11 per cent, respectively, over the last 7 years.

Two AMCs, UTI MF and Motilal Oswal MF, offer index funds based on this index. These were launched in March 2021 and January 2022, respectively. While it’s still too soon to assess their performance, high-risk investors can keep this index on their radar for future – for a small exposure in their overall equity portfolio.

Nifty100 Quality 30 Index:

The Nifty100 Quality 30 Index comprises the top 30 companies selected from the parent index based on their quality scores. ‘Quality’ companies are defined as those with high profitability (return on equity), low leverage (debt to equity ratio), and low earnings volatility. The stocks are weighted based on their quality score and their free float market cap, subject to a 5 per cent cap.

The Nifty100 Quality 30 tends to lag the Nifty 100 on returns – 3-5-year rolling returns (CAGR) of 8-8.4 per cent versus 10-11 per cent. Its USP lies in its ability to provide good downside protection, that is, falls less in periods of uncertainty and weak economic growth. Over the last seven years, the quality index has captured only 86 per cent of the downside of its parent index.

Only one AMC, Edelweiss MF, offers a Nifty 100 Quality 30 Index fund (earlier an ETF). The fund is less than six months old and charges an expense ratio of 0.27 per cent under the direct plan. The index itself has been in existence since March 2015.

Nifty equal weight indices: Unlike the momentum and quality indices that have outperformed their respective parent indices, to a large extent, the Nifty 50 and the Nifty 100 Equal Weight indices do not show a consistent trend of outperformance.

The market cap (MC) and equal weight (EW) indices go through alternating periods of out / under performance. Typically, EW indices fare well during periods of broader market rallies and underperform when there is polarization, as was seen over the last few years when a handful of stocks drove the bulk of index returns. While mean reversion – return to more dispersed returns from the earlier polarized returns – would dictate outperformance by EW indices going forward, their mixed performance record does not provide a strong case for investing in them.

To understand the low volatility strategy and funds based on the same, read here.

Published on February 19, 2022
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