Are Index Funds the Best for Long-Term Investment?

Posted on by WealthDesk
Are Index Funds the Best for Long-Term Investment? WealthDesk

In this Article

Index funds are a type of mutual fund scheme in which at least 95% of the portfolio is invested in the securities of a particular index. Index funds track an index, like the Nifty 50, S & P Sensex, etc., and invest in the securities that the index invests in. There is no active fund management as the portfolio mirrors the benchmark index. As such, index funds in India are also called passively managed mutual fund schemes.

Now that you have understood the basic concept of index funds in India, let’s come to the main question, are they the best investments over the long term?

There are various benefits of investing in index funds that work in their favor. Some of these benefits which make index funds the best long-term investments are as follows:

  • Benchmark-linked returns
  • Cost-effective 
  • Diversified portfolio
  • Suitable for new investors

Here’s a look at each benefit in a little detail:

  • Benchmark-linked returns

Since index funds mirror a particular benchmark, their returns also match the returns of the same. Actively managed mutual fund schemes, on the other hand, try to beat the benchmark returns, but such an endeavor might not hold consistently. In the last year itself, i.e., 2020, many actively managed mutual fund schemes have fallen short of their benchmark indices in terms of returns, as reported by the SPIVA India Scorecard. Have a look:

Type of mutual fund schemeComparison benchmark indexAverage equal-weighted fund returnReturn from the index
Large-cap equity fundsS & P BSE 10032.46%36.48%
Mid and small-cap fundsS & P BSE 400 MidSmallCap Index42.27%42.51%
ELSS schemesS & P BSE 200 33.96%36.59%
Government bondsS & P BSE India Government Bond Index3.06%3.81%
Composite bondsS & P BSE India Bond Index3.14%3.91%

As you can see, the benchmark returns exceeded the average returns of the actively managed mutual fund schemes. Index funds deliver benchmark matching returns (adjusted for tracking error and TER). As such, over the long term perspective, investing in index funds can prove profitable. 

  • Cost-effective 

Index fund investments in India have very low expenses associated with them. Since the fund is managed passively, the fund management charges are minimal. Thus, the costs are low and don’t eat into the returns generated by the portfolio, making them cost-effective schemes. 

  • Diversified portfolio

Benchmark indices invest in 50 or more stocks across industries and sectors. Since index funds also invest in the stocks comprising the benchmark index, you get the benefit of a diversified portfolio by investing in index funds. Your investment is split across large-cap, mid-cap, and small-cap stocks belonging to companies in different industries. As such, the volatility risks are mitigated under these long-term funds while the return generating potential is enhanced. 

  • Suitable for new investors 

Investors who are new to the world of equity investing find investing in index funds preferable. This is because they don’t have to pick the best stocks as index funds do it for them. Moreover, the benchmark matching returns, low-cost structure, and diversified portfolio make investing in index funds suitable for new investors who are looking for long-term investment options. 

Index funds in India, therefore, can be one of the best investments over the long term.

The flip side

While index funds are beneficial long-term funds, there are some drawbacks too. Have a look:

  • When the market is rallying, actively managed schemes can give benchmark beating returns, a feature that is absent in index funds.
  • In a downtrend, you can incur considerable losses under index funds. This is because the fund tracks the index, and there is no leeway to change the portfolio allocation to reduce risks. As such, even if there are hedging opportunities, such opportunities cannot be utilized due to passive fund management.
  • You do not control the stocks in the portfolio. The portfolio allocation is solely decided by the underlying index, making it impossible for you to invest as per your investment strategy, especially if you are a seasoned investor. 

What should you do?

While index funds are good, they might not be the best long-term investment avenue. Do not depend on them completely. Instead, you should diversify your portfolio with other investments, such as actively managed investments that can be modified as per your strategy. Another alternative to investing in an index is an Exchange Traded Fund (ETF) which functions as an index fund but is easily tradable on the stock exchange. So, with ETFs, you get the benefit of trading. 

Alternatively, you can choose a basket of stocks and ETFs matching your investment strategy, which enjoys hands-on professional management. WealthBaskets provides such readymade baskets that allow you to invest in a portfolio of handpicked stocks and ETFs. Moreover, there are different types of WealthBaskets to choose from as per your investment strategy.

The Bottom line

Index funds are profitable avenues, but you need diversification in your portfolio. Understand the pros and cons of these funds and then make an informed choice. 

FAQs

Which index fund is the best for the long term?

You should compare the different funds based on their historic returns and consistency. The fund which offers the highest and the most consistent returns would be the best for the long term. Comparing and selecting is the best way to invest in index funds.

Is it the right time to invest in index funds?

If you are looking for benchmark matching returns, investing in index funds makes sense. There is no right or wrong time for investing in index funds. You can invest any time, and if you have a long-term perspective, you will get attractive returns.

Are index funds good for the long term?

Yes, over the long-term period, index funds can give you attractive returns and smoothen out the volatility risks. 

Are index funds still profitable? 

Index funds match the returns generated by their benchmark index. So, if the benchmark index is delivering good returns, the fund would be profitable.