One of the biggest index fund advantages of investing in Index Funds is that it results in a disciplined investment approach. On the contrary, one of the biggest index fund disadvantages is that these are not actively managed. Hence, the returns from small or midcap stocks can not be factored in.
Before we delve deeper, let’s have an overview first.
Index mutual funds have portfolio matching/tracking a particular index like NIFTY 50, SENSEX, etc.
Index fund investing is also known as passive investing as the investor does not actively have to pick stocks from the market.
It is one of the safest investment instruments since it has lower expense ratios and suitable for low-risk investors.
In this blog, let us discuss the index fund advantages and disadvantages.
Advantages of Investing in Index Funds
Advantage #1: A Disciplined Investment Approach
The main advantage of index investing is that it entails a disciplined investment approach and investors/fund managers do not usually try to time the market.
Advantage #2: Saving in Brokerage Costs
Since the portfolio is based on a particular index, there is less churning of the portfolio which saves brokerage costs. Also since there is minimum fund manager involvement, expense ratios are also minimum.
So if an investor wishes to allocate to mid-caps, he/she can have a certain allocation to NIFTY Next 50 index funds/ETFs.
Another good index that investors can choose to track via index funds/ETFs is NIFTY 50 Value 20. It is not widely distributed but it had a stellar performance record till last year, beating NIFTY 50, NIFTY Next 50, SENSEX, and other large-cap actively managed fund’s returns.
Advantage #3: Lower Expenses
Along with having lower expense ratios, index funds are also super tax-efficient. Unlike active funds, an investor does not need to switch the funds depending upon its performance.
This helps in saving huge amounts of taxes (short term capital gain taxes).
Advantage #4: Ideal Strategy for Conservative Investors
For conservative investors who wish to have equity asset class exposure, index fund investing is an ideal strategy.
Although index funds are an ideal investment instrument for conservative investments, they also come with their set of disadvantages.
Let us take a look at the disadvantages of index investing.
Disadvantages of Investing in Index funds
Disadvantage #1: Less Exposure to Mid and Small Cap Stocks
Index funds offer good exposure to large caps, however, there are fewer indices offering exposure to small and mid-caps.
In this case, small, medium and multi-cap actively managed funds have performed much better than index funds. Thus, in these categories fund managers still have an edge over index funds.
Thus, if an investor with aggressive risk tolerance wants to invest for a horizon for 7-10+ years, he/she should go with small and mid-cap mutual funds.
These funds offer better returns on a longer horizon. Also, it is better to invest in these stocks through the mutual fund route instead of direct equity as there is not enough information available to research about these stocks, for a retail investor.
Disadvantage #2: Not Actively Managed
Since index funds are not actively managed and most of the indices are market-weighted, sometimes a stock that is performing too well gets higher weightage in the index.
This creates a dependency of the fund on the performance of that particular stock.
For example, currently, Reliance Industries has ~14-15% weightage in NIFTY 50 which is the highest.
Thus an Index fund/ETF tracking NIFTY 50 will have more dependency on the performance of Reliance Industries. If the stock price nosedives in the future, index returns will also fall.
Disadvantage #3: Not Aggressively Distributed Due to Low Commissions
Also, since Index funds have lower expense ratios, these are not that aggressively distributed as compared to active mutual funds.
This is because the main income for Mutual fund houses is through the expense ratio. Since Index funds have a lower expense ratio (lower income for fund houses), mutual fund houses do not have much incentive in aggressively distributing these funds.
This is also one of the major reasons for the lower penetration of passive investing in India as compared to developed countries like USA.
Also Watch: Index Fund Advantages and Disadvantages
As we have discussed the pros and cons of Index investing, the bottom line is that it is always better for a beginner to start his/her investment journey with Index funds.
After the index investment, investors can move up the hierarchy with active mutual funds and then direct equity investments depending on his/her risk tolerance.