An Index mutual fund is a fund that tracks the component of an index, such as Nifty 50. It provides exposure to a broad market. Index is generally weighted by the stocks with respect to their Market Capitalizations, and it represents around 60% of the value of all Indian stocks.
Indexing is a passive form of investment; it works because of Efficient Market Theory.
Efficient Market Theory states that share prices reflects all the existing information and expectations, so it is impossible to outperform overall market via stock selection or market timing. Analysis done by Morning star Inc, suggests that Efficient market theory works. The Morningstar Active/Passive Barometer is a semi-annual report that measures the performance of active funds against passive peers in their respective Morningstar Categories. The study concludes that:
“Actively managed funds have failed to survive and beat their average passive peer, especially over longer time horizons; one out of every four active funds topped the average of their passive rivals over the 10-year period ended June 2022”
Why Index fund beats most fund?
1) Less Expense Ratio: It incurs only nominal administrative and managerial fee.
2) Less Transaction Cost: Portfolio turnover is minimum, so almost no transaction cost.
3) No drag of uninvested money: Index is 100% invested in equity whereas normal fund will hold some uninvested cash reserves. This difference can be favourable in rising market and unfavourable in declining markets.
4) Less Capital Gain Taxes: Since portfolio turnover is low, index funds are less likely to realize and distribute capital gains.
Of course, there will be few active mutual funds that will outpace the index returns but you have to think two questions:
1) Can these funds be identified in advance?
2) Will the superiority in performances surpass the extra costs being charged?
Let me know in comments what are your thoughts on Indexing?
Read this article or watch our session to know how to analyze a mutual fund.