As per AMFI data, the average return provided by most index funds in the last three years is over 25%. The annualised growth rate of AUM (Assets Under Management) of the index fund industry in 5 years was 53%. It has grown over 8 times from Rs. 80,755 Crore to Rs. 6,50,353 Crore between March 31, 2018 and March 31, 2023.
But what is the reason for this massive faith of investors in the passive funds or index funds industry in India?
There are many reasons. One of the main reasons is the high return of index funds over the years. Other reasons include the potential for wealth creation in the long run, the ability to get an experienced and qualified fund manager to manage your funds at an affordable cost, and the ease of investing.
Experts believe index funds have gained traction because of SIP in index funds, an investment strategy that enables investors to invest regularly at an affordable cost, irrespective of the NAV (Net Asset Value). Before explaining an index fund’s SIP or Systematic Investment Plan strategy, it is important to learn what an index fund is.
What are Index funds?
An index fund is a special kind of mutual fund that mimics the performance of market indices such as Nifty 50. That is why it is also called passive mutual funds.
In the case of equity mutual funds, the fund managers choose, invest, and manage stocks as per their market research on behalf of their investors. However, in the case of index funds, the fund managers invest in stocks in an index, such as Nifty 50. The investment is usually done in the same proportion as the weightage of the stock in a specific index, say, Nifty 50 or Bank Nifty.
The objective of passive mutual funds such as index funds is to provide its users with a return that closely mirrors the returns provided by the index. You can invest either through lumpsum or SIP in index funds.
What is SIP in Index Funds?
SIP stands for Systematic Investment Plan. This investing strategy is based on the famous Dollar Cost Averaging (DCA) method, which was popularised by the renowned investor, Warren Buffet. In India, this strategy is called the Rupee Cost Averaging method of investing.
SIP investment enables investors to invest a fixed amount of money (say, Rs. 100 or multiples of Rs. 100) regularly (weekly, monthly, or quarterly). Instead of lumpsum investment, SIP investing is done on a regular basis, which is similar to a recurring deposit. Usually, SIP is done in an automated way through standing orders to banks (NACH mandate), which makes the entire process hassle-free.
Index fund SIP enables you to invest a certain amount of money in a selected index fund every month or in a specific interval regularly or consistently irrespective of the fund’s price. Whether NAV (Net Asset Value) is high or low, SIP in index funds encourages you to keep investing in an index fund over a longer period of time to accumulate wealth.
SIP in index funds is an investing strategy that helps you to grow your wealth by mimicking the overall market’s growth. Whether the index you mimic is Nifty 50, Bank Nifty, or other, you inadvertently participate in that specific index’s growth trajectory. The best thing is that no deep research is required before investing. You can simply use a SIP calculator and start investing.
If you have faith in the growth story of India and the different sectors on which the indices are based, you should invest in index funds. You can lower your risk of investing and at the same time enjoy significant growth in your wealth by adopting the SIP investment route. Regular investing through SIP in index funds helps you invest regularly in passive equity funds and enjoy the advantages of Rupee Cost Averaging. You may explore different index funds and mutual fund schemes before investing in a specific fund through SIP.
How to start SIP in index funds?
A step-by-step guide to initiating a systematic investment plan (SIP) in index funds:
- Define your investment objectives: Begin by assessing your risk tolerance and financial goals. Whether you're aiming for short-term objectives like purchasing a vehicle or long-term aspirations like retirement, clearly defined goals will shape your investment strategy.
- Select the appropriate index fund: Carefully choose an index fund that aligns with your investment horizon and risk profile. For instance, if you seek exposure to India's top 50 companies, a Nifty 50 Index Fund would be suitable. Consider factors like expense ratio, tracking error, and historical performance when making your selection.
- Establish an investment account: Open a mutual fund account with a reputable fund house or brokerage firm. This process involves completing Know Your Customer (KYC) formalities, which typically require identity and address proof.
- Determine your SIP amount and duration: Decide on the amount you wish to invest regularly and the desired duration of your SIP. Align your investment amount with your financial capacity and long-term goals.
- Automate your investments: Set up auto-debit instructions from your bank account to your investment account. Automating your SIPs ensures consistent investments, regardless of market fluctuations or personal commitments.
- Monitor your portfolio: Regularly review your index fund portfolio's performance. While index funds generally track market indices, staying informed about market trends and economic conditions is crucial for making informed investment decisions.
Why to choose Index Fund SIP?
You should choose an index fund SIP to enjoy the following benefits:
- Avert volatility risk of investing
When you use the SIP investment technique, you can buy more units when the price is low and fewer units when the NAV value is high. As SIP enables you to invest regularly (weekly, monthly, or quarterly), the Rupee Cost Averaging averages your total investment cost over time. So, SIP in an index fund shields your investment from the volatility risk of the market. The best part is that you get a decent return over time, your wealth increases, and your investment gets shielded from volatility risk. - Diversification of investment
You do not have to invest in different stocks to achieve diversification. As an index such as Nifty 50 is created by including the top 50 stocks of India, you get instant diversification benefits by investing in index funds, which mimic an index. - Minimal cost
You may get a higher long-term return from index fund SIP because passively managed funds such as index funds have minimal cost. This keeps the expense ratio low, especially when compared to actively managed funds such as equity mutual funds.
In comparison to lumpsum investments, you can start investing in index fund SIPs from as low as Rs. 100 per month. So, anyone can start investing regularly and enjoy the benefits of wealth accumulation. Always compare mutual funds before selecting.
Benefits of starting an SIP in index fund
Investing in Nifty 50 or other index funds through a Systematic Investment Plan (SIP) offers several compelling benefits:
Diversification:
- Broad exposure: Index funds, such as the Nifty 50, provide exposure to a diverse basket of leading companies across various sectors.
- Risk mitigation: This diversification reduces the impact of fluctuations in individual stocks, mitigating investment risk.
Cost-efficiency:
- Lower expense ratios: Index funds are passively managed, resulting in lower expense ratios compared to actively managed funds.
- Long-term growth: These cost savings can significantly contribute to long-term wealth accumulation.
Objective investment approach:
- Rule-based strategy: Index funds adhere to a predefined, rule-based investment strategy, eliminating the potential biases associated with active management.
- Consistent performance: This systematic approach often leads to consistent and reliable long-term performance.
By leveraging the power of SIPs and index funds, investors can establish a disciplined investment routine and benefit from the potential of long-term market growth.
How to select the right funds?
To initiate a successful index fund Systematic Investment Plan (SIP), consider the following factors:
- Expense ratio: The expense ratio represents the annual fee charged to manage your investment. Lower expense ratios directly translate to higher returns. Index funds, particularly those tracking broad market indices, typically have lower expense ratios than actively managed funds due to their passive investment strategy. However, even within the index fund category, expense ratios can vary. Prioritise funds with the lowest possible fees to maximise your long-term returns.
- Tracking error: Tracking error measures the deviation of an index fund's performance from its underlying benchmark index. A lower tracking error indicates a more accurate replication of the index. Consistent tracking errors within acceptable limits are a hallmark of a well-managed index fund.
- Fund size and liquidity: Larger index funds tend to be more liquid, facilitating smooth buying and selling of units. While smaller funds can also be effective, it's essential to ensure they have sufficient assets under management to avoid liquidity constraints.
Should you start SIP in index funds?
Index Fund Systematic Investment Plans (SIPs) offer a straightforward investment approach with several advantages:
- Diversification: By tracking a specific market index, index funds spread risk across a wide range of securities.
- Lower costs: Typically, index funds have lower expense ratios compared to actively managed funds.
- Potential for long-term returns: Over extended periods, index funds have historically demonstrated the potential to outperform actively managed funds.
Key considerations:
- Time horizon: For optimal results, it's advisable to maintain a long-term investment horizon of at least five years to mitigate short-term market volatility and harness the power of compounding.
- Tax implications:
- Short-term capital gains tax: If units are sold within one year, a 20% tax rate applies.
- Long-term capital gains tax: For holdings exceeding one year, a 12.5% tax rate applies on gains exceeding Rs. 1.25 lakh.
- Indexation benefits: Unlike other investments, index funds do not offer indexation benefits.
Conclusion
If you want to grow your wealth in the long term by avoiding volatility risk and also enjoying flexibility, SIP in index funds is one of the best ways available. Over the long run, index funds SIP will provide compounding returns, especially if you opt for reinvesting capital gains and dividends. This disciplined investing approach will grow wealth in the long run by harnessing the power of compounding and Rupee cost averaging.
