Equity and debt mutual funds have a lot of subcategorization, and most importantly, they are actively managed by their respective fund managers. The active fund manager tries to generate a higher return (alpha) over the benchmark returns.
There has been a long debate about active vs. passive investing. Let’s understand it in greater detail.
Index funds are mutual funds that aim to replicate market index performance. The first index fund was launched by the legendary John C. Bogle, who named it the first index investment trust, which was later renamed the Vanguard 500 index fund. This gave birth to passive investing.
We know that active management of funds involves analyzing and picking stocks, while passive investing involves investing money in a benchmark like the Nifty 50 index. While the actively managed funds try to outperform the benchmark, the passively managed index funds replicate the performance of the benchmark.
If you are a new investor, you might wonder why we need index funds or passive investing, as highly skilled managers must be doing an excellent job of outperforming the benchmark.
Let us enlighten you with some interesting (and somewhat shocking!) facts - according to the SPIVA report, at the end of the first half of 2022, more than 80% of the large-cap funds failed to outperform their benchmark over a 5-year period.
The active funds have a high expense ratio, which increases the overall portfolio management cost and in turn, decreases the actual returns. Direct funds have an expense ratio of around 1%, while regular funds have an expense ratio of more than 1%. On the other hand index funds have an average expense ratio of only 0.3% (or even less for funds tracking Nifty 50 TRI). Index Funds today are a great option for investors looking at a long-term, systematic form of investment.
Both of these terms seem similar but they are very different. Tracking difference is the difference between the returns of the index fund and the benchmark index. For example, if nifty goes up by 10% and a nifty index fund goes up by 9% then the tracking error is -1%. When the tracking difference is negative, we can say that the index fund has underperformed the index and vice versa.
Tracking error is the measure of the variability in the return of the index fund compared to its index. Mathematically, tracking error is defined as the standard deviation between the benchmark and the index fund. In general, tracking error is calculated as follows:
In simpler terms, it shows how tightly the index fund is hugging the index. A low tracking error means the index fund is performing similarly to the index (which is desirable). Likewise, A high tracking error indicates that the fund returns are not similar to the index.
In the above table, we have shown tracking error and tracking difference of the last 12 months of 3 mutual funds managed by HDFC AMC. Here, we have to understand that the tracking difference can be negative or positive as it is the absolute difference between the fund and benchmark returns. But the tracking error will be always positive as it is the standard deviation between the fund and benchmark returns.
No, even though both of them might have a similar underlying asset (Nifty, Banknifty, gold, etc.), they have one striking difference. Fund units of ETFs are tradable on a stock exchange while units of index funds have to be redeemed. This provides more liquidity for ETFs compared to index funds.
Index funds that follow broader market indices (like Nifty 50) can be a great investment in the long term, as benchmark indices have logged more than 10% CAGR return in the long term. But sector-specific index funds can be more tricky and require an in-depth understanding of the sector.
If you have a low-risk appetite and plan to invest only in large-cap stocks, then investing in a Nifty 50 index fund will be a better choice. The primary reason is that more than 80% of the actively managed large-cap funds can’t beat the index over a five-year horizon. Actively managed funds are better in the small-cap category, as more than 80% of the actively managed small-cap funds have outperformed the benchmark over a three-year horizon