How to invest in index funds

Some of you wish to invest in index funds and want to know the best index fund to buy into. Others want to hold a portfolio of index funds and end up with all high-risk indices or all large-cap indices. But building a portfolio out of index funds or adding index funds to an existing portfolio calls for mixing and complementing strategies and market-cap segments to ensure diversification of risk across market cycles.

To this extent, passive investing too requires asset allocation and planning. Yes, you may choose to invest in just one Nifty 50 index fund believing that is all you need. There is nothing wrong with that thought. This article is not for such investors.

In this article, we’ll try to explain the key characteristics of some of the equity indices and how they can be paired with other index funds/ETFs or with active funds. But please note:

• This is not an article on active vs. passive investing. You can look up for our article on that in our blog.
• We will be discussing only equity indices.
• This will not cover every index for which there is an index fund/ETF. We will try to cover some of the more popular ones.
• We will not be discussing thematic indices.
• Debt does not have sufficient options across time frames, in the passive space. Most of the products available are for medium to long duration. But we will still cover this in a separate article.

Large-cap indices

We have given below some of the large-cap or large-cap oriented indices for which there are index funds or ETFs. These indices are either large caps or derived from large -cap indices such as Nifty 50 or the Nifty 100

What are the large-cap indices?

• You have the traditional Nifty 50, Nifty 100, or Sensex indices.
• Then there are strategies derived from the traditional indices. For example, the Nifty 100 Low Volatility 30 is a set of 30 stocks from the Nifty 100 with least volatility score (as defined by the index maker). The Nifty 50 Value 20 is a portfolio of 20 stocks that are considered ‘value’ derived from the Nifty 50.
• Some of the strategies may be debatable. For example, the Value 20 index has IT and FMCG as top stocks and these are not particularly ‘value’. A combination of dividend yield, ROCE, Price to book and Price to earnings filters used by the index has pushed stocks from high-quality sectors as ‘value stocks’. But this has more to do with the methodology of the index itself and not something we can do anything about. Suffice to know that what you get in these indices may not be what you perceive as value.
• The Nifty 50 equal wight is nothing but an index with equal weight to the Nifty 50 stocks.

Visit https://www.niftyindices.com/ to know the methodology of calculation of the indices.

Large-cap index performance

Now for the risk and performance of these indices. The first table gives you returns rolled daily for 1-year period over 3 years. That’s about 745 observations. The second table gives you 3-year returns rolled daily with similar observation points as above.

• The Nifty 50, Nifty 100 and Sensex by and large have similar statistics – that is, their average returns are not way apart although the Sensex sports slightly higher average returns at this juncture. This can change in different market phases.
• The Nifty 50 is a more concentrated index than the Nifty 100, given the fewer number of stocks. Hence, the Nifty 50 may outperform in prolonged rallies. That is likely what you are seeing in the 1-year return difference between Nifty 50 and Nifty 100.
• Low Volatility and Value indices have beaten the other traditional indices due to their ability to contain downsides better. It is important to note that the other indices delivered higher maximum returns than the low vol/ value indices. That also means that the latter indices may lose out on strong rallies (a phenomenon we have seen in value). But overall, it is lower volatility that appears to deliver higher.
• The equal weight Nifty 50 is meant to participate equally across the Nifty stocks. That means it ought to fall less in sharp down markets and rally less in up markets (lower weight to rallying stocks compared with the Nifty). But it hasn’t done this and has in fact more proportion of negative returns than the Nifty 50 – falling more in the March 2020 correction and slipping into negative returns (1 year return) in the tepid market of 2018-19 when select stocks alone outperformed. At this juncture, we don’t view this as a serious contender in your portfolio.

How to use large-cap indices

• The Nifty 50, 100 or Sensex can be large-cap substitutes for your active portfolio or can be part of your large-cap allocation for your all-passive portfolio if you have moderate risk. If you already hold large-cap funds that are performing well, you don’t particularly need these unless you want to diversify because your corpus in large. In this, Nifty 50 is more volatile than the Nifty 100 and the Sensex 30 over shorter periods of 1 year. You may take this risk profile into consideration while choosing between these indices.
• The Low Volatility index can fit if you prefer smaller falls in your portfolio if you already have an aggressive active portfolio. You can substitute it for the traditional indices mentioned in point 1, provided you know that they can underperform in rallies. For example, at present the Nifty 100 beats the Low Vol index by 10 percentage points over a 1-year period (point to point). Read more about it in our review here.
• The Value index can be skipped if you like true to label ‘value’ stocks with depressed valuations available only with active value funds. This index’s portfolio will not sport such stocks. But if you choose to add a value index, count this as part of your large-cap allocation. Here again, know that value can underperform for prolonged periods. The average returns in the tables above may not tell you the underperformance story. For e.g. The later part of 2019 till the March 2020 correction saw the Nifty comfortably outperforming value as markets were touching a peak and growth stocks zoomed.

You can view all the above indices as substitutes for large caps and flexi caps.