To add equity exposure in our portfolio, all the financial experts recommend index funds.
What is so special about Index funds? Why everyone including Warren Buffet is recommending that?
Lets check that out in detail in this episode.
My name is Vijay Mohan. You are watching - Investment Insights.
Before looking into an Index fund, lets understand what an Index is.
There are 2 major stock exchanges in India. BSE - Bombay Stock Exchange and NSE - National Stock Exchange.
NSE is bigger in trading volume. So lets focus on that.
About 2000 or so companies are trading in NSE. We all know that a share price of a company moves up and down every day.
How can we measure the performance of the whole stock market?
We need a benchmark for that. Index is that benchmark.
Lets see how an Index is created using Nifty 50 Index as example.
Nifty 50 uses Market cap Weighted Methodology. What is that - you may ask.
Lets check that out using a small calculation.
Top 50 companies based on market cap is in Nifty 50. What is market cap?
Not sure if you remember. If you don’t watch “Understanding Sharemarket” video in this channel again.
Market cap is the total market value of a company.
That is, if a company has 1000 shares and if the price of each share is Rs. 10, then the market cap of the company is 1000x10=10,000.
There are 50 companies in Nifty 50. Here in this list, we are seeing company 1 thru company 50.
Each company’s market cap changes based on its size (value).
In our example, the biggest company has a market cap of 7. Then we have 6, 5, 4, 3, 2 as the market cap of next 5 big companies.
Lets have the rest of the 44 companies in this index to have a market cap of 1.
The total market cap of all the 50 companies is what we are seeing as 71 at the top. This is the index.
Company 1 has a market cap of 7. Of all the companies, this is the biggest.
What is the share of this 7 in the total market cap of 71? That % is what we are seeing as weightage in the third column. Almost 10%.
What does that mean? If the stock price of this company moves by 10%, the impact of that move will be 1% in the total market cap.
That is, a change of 10% in this company’s stock price alone would move the index by 1%.
Lets change this market cap value by 10% - from 7 to 7.7.
Now we can see that this has changed the total market cap to 7.7, an increase of 1%.
We can see that the weightage of company 1 has now changed from 9.86 to 10.74 as well.
This is market cap weighted index. Big companies price movement makes a bigger movement in Index.
Small companies price movement makes a smaller movement in index.
When a small company grows, the impact of its price movement to the index grows as well.
That is all to understand about Nifty 50’s construction methodology. Simple.
Now lets take a look at the actual Nifty 50.
Adani Ports is only 0.84% in the index. HDFC Bank 9.79%, Reliance 10.36%.
Again, all this weightage is coming from the market cap size of the company.
This is Nifty 50 Index. Nifty Next 50 is the index formed using the next top 50 companies based on market cap.
It is constructed using the same methodology as well.
What if both these indices are put together? That will be top 100 companies. That is Nifty 100.
Now a question for you. I have Rs. 100. I am investing Rs. 50 in Nifty 50 and the other 50 in Nifty next 50.
My friend invests all Rs. 100 in Nifty 100. Would the performance of our portfolio be the same? Enter your answer in comments below.
So just like these Nifty 50 and Nifty 100, there is Nifty 200, Nifty 500.
But we use Nifty 50 as a general representation of Indian stock market.
Because the Nifty 50 itself takes up 70% of the Nifty 500 in market cap.
That is why we are using Nifty 50 as the proxy for Indian stock market.
BSE’s Sensex Index - BSE 30 is also created using the same methodology.
If Nifty 50 has top 50 companies, BSE 30 has top 30 companies. That is all the difference.
What about US Index S&P500? ;)
So, whats the use of this index? Like I mentioned before, this is the benchmark.
Lets say that we are investing in individual stocks.
We can use this benchmark to compare the performance of our portfolio.
We can also use this benchmark to track whether an actively managed fund is consistently beating it or not.
But the biggest use of this benchmark for us is to see how the stock market is performing in the current market.
Now if a fund is created based off of this index, then that is called as Index Fund.
What are all the companies that makes up the index and its weightage is a public information.
What if we create a portfolio with the same companies and with the same weightage?
That is what each fund house is doing. HDFC, ICICI, UTI, SBI - all mimic this index and create an Index fund of their own to offer to their clients.
We can buy the one that we like. As long as the fund is following the underlying index, the returns will be same.
Some fund houses offer ETFs based off of the same index.
In a mutual fund, Net Asset Value (NAV) is calculated only at the end of the day.
But the price of an ETF changes like a stock in real time.
That trading price could be the NAV of the ETF or could be higher.
When the liquidity of the ETF is high, there will not be any difference between the price and NAV.
In US, most of the ETFs have high liquidity. So the trading price is not a problem in US.
But the liquidity is very less in India. That could lead to higher price of the ETF than the NAV of the underlying assets.
Could we buy a 50 paise coconut barfi for 55 paise?
So in India, it is better to buy an Index fund than an ETF for long term investing.
Actually, that small difference in price is not going to make a big difference in long term. But still, Index funds are better.
OK. When it comes to stock market, why should one invest in an Index fund? What advantages does it have?
First advantage - This index is the market. This is the benchmark.
What does that mean? Everyone tries to beat this index.
Among those who is trying to beat the index, how many have won consistently?
Even 90% of the fund managers were not able to beat the index consistently. What chances do we have as retail investors?
When we can buy this hard to beat index itself, should we even have to think about it?
After challenging that, “I am the benchmark. Beat me if you can”, we can easily invest in an index fund.
Next advantage is simplicity. To invest in this index fund, there is no need for any complicated research or analysis.
It does not need any specialized knowledge as well.
We can just buy it and forget it and let it run in auto pilot.
But if we buy an actively managed fund, we have to watch it closely to see if it is beating the index.
It is even worse with individual stocks. We have to monitor them every day.
I am saying this as an advantage. It is an advantage purely from investment perspective.
But those who see this as disadvantage would say, “this index is very boring. We got nothing to do…
The thrill from following a stock closely, buying and selling, is not here in this Index fund.”
One who expect thrill from money, can visit a casino. It offers even more thrill.
I am joking. I can understand. We cannot compare the thrill of following a stock everyday to casino.
If you like that thrill, you can definitely use that for your learning. Nothing wrong in that.
Who knows. There could be a Warren Buffet inside you. Why would I discourage that.
If you are seeking thrill, feel free to venture into individual stocks.
Another advantage with index fund is “Diversification”. All market sectors are automatically included in the index.
So there is no need to worry about diversification.
We dont have to guess which sector will do good next decade as well. That will be automatically included as well.
Next advantage is Fees - When compared to actively managed funds, the expense ratio of index funds are way cheaper.
That is management fees are very cheap.
It is not going to cost much for the fund house to mimic an index that already exists.
Next advantage is - we dont have to predict the next Infosys or next TCS.
A good company that is growing up well will be represented well in the index as well.
If we look at the history of S&P 500, the biggest companies have changed every decade.
Before 2000, IBM, Exxon and GE kinds dominated the index. Now Apple, Microsoft, Amazon kinds are dominating.
If we are investing in S&P500, there is no need for us to guess which companies will dominate in the next decade.
They all would be already part of the index.
Next advantage is Low risk. Investing in equity is high risk. No doubt.
But in equity, investing in Index fund would be the lowest risk.
So in summary, it is difficult to beat and index and it carries the lowest risk.
That is why it is a no brainer for common people like us to invest in an Index fund.
Even Warren Buffet recommends that.
Lets the stock market experts do all the research and analysis to beat the index.
We can invest in an Index fund and be relaxed and cool. We can just watch the game if the experts were able to beat it or not.
“This is wonderful. Let me start on this immediately” - Not so fast.
We need to understand the risks involved in this as well.
We will cover that in the next episode. Thank You.