Are index funds the new safe haven for investors?

Are index funds the new safe haven for investors? We need to consider a few more questions to answer this.

Index funds provide simple options to invest in during uncertain times like now.

They are the rage in mature markets such as the US and the UK.

With active funds failing to outperform benchmarks, investors are increasingly looking at simple, low-cost index funds for equity exposure.

Though the returns are a primary driver for the success of index funds and ETFs (exchange-traded funds), there are a lot of other reasons why they are effective for long-term investing.

Performance and returns

Index funds, due to their low-cost nature and simplicity, tend to perform better than average active funds, but are very rarely the top performers.

That is why one will never find an index fund in top 10 mutual funds lists. This is a good thing, because top performers rarely stay at the top.

Risks and uncertainty

An index fund is just like any other mutual fund. It may seem that index funds (especially the Nifty 50) are less risky in the current scenario, but investors should refrain from backward-looking bias.

Types of risks involved

Selection risk: How does one choose the right fund? It depends a lot on the fund manager, the investment philosophy and the long-term track record. Any investor chasing returns alone will end up with average returns. As the saying goes, “Chasing the herd will make you mediocre. The larger the herd, the worse the outcome.”

So, what an investor needs today is the capability to look beyond returns, which is hard. Index funds, therefore, are a safer option as they eliminate selection risk.

Performance risk: One big reason investors churn mutual fund portfolios is under-performance. Our recommendation is to churn mutual funds only for non-returns purposes. Index funds in this regard are great because they have little risk of under-performance.

Long-term risk: Active mutual funds may die or get merged, but index funds are expected to outlive them. Launched in 1976, the S&P 500 is the world’s first index fund. It is today the world’s largest index fund.

Track record risk: Index funds have a 15-20-year track record and, as a result, are a lot more dependent on delivering long-term returns. Investors with specific goals (such as buying a house/ car, funding children’s education) can plan them with greater ease.

Volatility risk: The risks index funds pose are very consistent.

It means that the volatility of index funds today versus the volatility of the same fund 10 years ago is similar.

The same cannot be said for active funds as their portfolios change often, and it is hard to predict the risk of a future stock portfolio or strategy.

The range of standard deviation of a large-cap fund is high.

So an investor may hold a large-cap fund with the risk of a small-cap fund, whereas an investor can assume that a large-cap index fund is less risky than a mid-cap index fund.

Portfolio risk: An investor who invests in four to six mutual funds is essentially buying the market, and, therefore, will find it hard to outperform the benchmark at a portfolio level. In any given portfolio of active mutual funds, some do well and some do not.

It is simpler to hold index funds.

So, index funds are simpler and less risky. Are they the right funds in volatile times? Not at all.

However, is it easy to hold them at all times? Definitely yes!

The writer is Head, Passive Funds Business, Motilal Oswal Asset Management Company