As some categories of active funds in India such as large-cap funds, have struggled to beat the sprinting Nifty50 and Sensex30 in the last couple of years, there’s a surge of interest in index investing.

Index funds boast of three clear advantages over actively managed funds. One, an actively managed fund can underperform the markets if the fund manager makes the wrong portfolio calls. Portfolio calls can go wrong on many counts – buying the wrong stocks, buying them at too high a price, holding too little weight in outperformers and too much in laggards, selling great stocks too early and so on and so forth. With index funds, there are no such uncertainties, as the fund simply mirrors an established index – where the performing stocks automatically receive more weight while the laggards are trimmed.

Two, with actively managed funds, annual expenses of 1.5-2.5 percent (on regular plans) can take a big bite out of your returns. With index funds, now available at less than 0.25 per cent (again regular plans) in India, you save big on costs.

Three, even if you pick an alpha-generating active fund, the fund manager you relied on can quit or change his style, making it tough for the fund to repeat its past record. With an index fund, the manager doesn’t matter.

But while index funds do save you from the above risks, there are certain risks inherent to investing in equities that they don’t shield you from.

Return volatility

If stock prices gyrate wildly, your index fund will follow suit too. For instance, if you owned a Nifty50 Fund for the last fifteen years, it would have declined 37 per cent in its worst month (September to October 2008), 40 per cent in its worst quarter (July to October 2008) and 57 per cent in its worst year (October 2007 to October 2008).

The nature of the index you choose to mirror will have a big bearing on your return volatility. In India, the Nifty Next50 index, which houses emerging bluechips, has traditionally been more volatile than the Nifty50 index. In the last fifteen years, the Nifty Next50 lost 37 per cent in its worst month, 48 per cent in its worst quarter and a breath-taking 67 per cent in its worst year!

Therefore, if you are looking to reduce return volatility you may have to scout for specific index products such as those mirroring the Nifty Low Volatility 30 index, to meet your objectives. 

Index funds in India often carry concentration risks because of their high weights in their top sectors and stocks. Such concentration has become more conspicuous in recent years, with select stocks in the index rallying and the rest flatlining.

Portfolio concentration

When you invest in equities, a key determinant of the risk you take is the composition of your portfolio – the weights you assign to individual stocks and sectors. The more concentrated a portfolio is, the more vulnerable it is to swings in performance. To reduce the risk of individual calls going wrong, a portfolio should ideally be well diversified across many sectors and stocks.

Index funds in India often carry concentration risks because of their high weights in their top sectors and stocks. Such concentration has become more conspicuous in recent years, with select stocks in the index rallying and the rest flatlining.

In fact, in January 2019, to curb concentration risks in ETFs and index funds, SEBI had laid down new rules on the composition of indices. It specified that broad market indices should have no more than a 25 per cent weight in their individual stocks, while sector/thematic indices should their stock weights at 35 per cent. The top 3 constituents in any index should not exceed 65 per cent. But these rules still allow concentrated portfolio positions in index funds. Leading indices in India have also been known to feature more than 10 per cent weights in their top constituents. BSE Sensex30 funds, for instance, had a 12.6 per cent weight in HDFC Bank and 11.2 percent in Reliance Industries in October 2019. Index funds tracking themes or sectors tend to have even higher concentration in individual stocks.

Such concentration risk is lower in most categories of active funds. To curb concentration, SEBI rules prohibit active diversified equity funds from investing more than 10 per cent of their portfolio in any single stock. Many active funds believe in even greater diversification and limit their top holdings to 5-6 per cent.  

Business or Governance risks

Your long-term returns in equity investing effectively come from the quality of the companies you’re holding in your portfolio. ‘Quality’ here may be defined by the company’s profitability, capital ratios, balance sheet strength, corporate governance, resilience to competition and many other factors. Index investing doesn’t guard you against the risks of a company slipping up on any of these factors.

The bellwether stock market indices in India such as Nifty50 and Sensex30 choose their constituents for their high free float market capitalisation, easy liquidity and low impact costs, and not for their business fundamentals. Therefore, it is quite possible for these indices to feature high-debt companies, loss-making companies, companies in financial trouble or even those with governance issues. Satyam Computers, Unitech, Reliance Communications and Yes Bank have all been part of the Sensex30 or Nifty50 in the past.

Over time, as business quality issues hit stock prices of troubled companies, they lose weight in the index and eventually get dropped. But in the meantime, investors in index funds may have no choice but to take the stock price gyrations in their stride. 

Apart from all this, you need to watch out for tracking error – the risk that your index fund will fail to match the returns of the index it tracks because of inefficiencies in mirroring it. These inefficiencies could arise from cash positions, frequent changes in the index or liquidity issues in index stocks. Funds based on indices such as the Nifty Next50 have tended to suffer from significant tracking error despite investing in liquid stocks.

It is important not to lose sight of the simple fact that index funds allow you to hug the market, not outperform it.