Prevailing market conditions strengthen the case for Equity Index Funds

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When it comes to selecting a mutual fund scheme for a portfolio, investors are often confused. ‘Which strategy should I invest in? Which sector is the next sunshine sector? Which segment of the market will gain or lose the most due to ongoing developments?’ These are some common investor questions.

While individual risk appetite and financial goals should be the guiding principles for these selections, some broader steps can be taken by investors to diversify and improve the risk-return profile of their portfolio.

Investor’s dilemma

When it comes to equity investments, we can broadly classify retail investors into two categories. The first set of investors have experienced market volatility in the past. They are ready to take a reasonable amount of risk in search of higher returns. Investors in the other group, though keen on having a taste of the equity markets, are wary of the associated risks.

Actively managed equity funds can be a preferred choice in the first category. The second group can get their feet wet in the market through passive products, such as index funds.

To be sure, increasingly, more and more investors — including experienced investors — are opting for index funds in their portfolio, along with other active funds of their choice. Since April 2021, the number of folios in Index Funds — Equity and Debt combined — have grown over 2.5 times.

What is driving this behaviour? One likely answer is the prevalent volatility in the market.

Seeking some stability in volatile markets

The markets have witnessed a reasonable amount of volatility in recent months. The equity markets, for instance, had reached a peak in October last year and are again within striking distance of the same peak, after being through a few drops and advances. Going by the global developments on the geo-political front and inflationary concerns in major economies, including India, volatility is likely to be around for some more time.

Nevertheless, the Indian economy and equity markets have shown remarkable resilience compared to other developing and developed countries.

Beyond event-driven volatility, we continue to be optimistic on the Indian growth story. We continue to believe that there are enough new opportunities in Indian markets to be tapped through active strategies.

However, active fund management risks are a reality, as well. In such a situation, Index Funds can aid in reducing the active fund management risk in an investor’s portfolio.

Understanding equity index funds

Index funds are a category of mutual funds where the fund simply mimics an underlying benchmark index that it is tracking. Accordingly, there is no active stock selection, and hence, no selection bias involved. This brings benefits in terms of transparency and cost. The fund’s performance is likely to be in sync with the performance of the underlying securities of the benchmark.

Broadly, equity index funds can be further grouped based on market cap, sector or theme. Within the market-cap bucket, large-cap index funds track the performance of established companies, which are often called blue-chip companies.

Then come the mid-cap index funds. These track the performance of companies that are emerging businesses with high growth potential. Some of these companies are already market leaders in their respective niches.

Similarly, the small-cap segment includes companies that are at a nascent stage and have the potential to become the next multi-baggers. This category is home to new ideas and business models being tested. Both mid- and small-cap companies have the potential to become market leaders in the future.

Accordingly, investing in mid- and small-cap index funds can be a good medium for investors to diversify their portfolio along with the opportunity for wealth creation.

Having the right mix is key

Among the most important lessons of investing in mutual funds is that there is no one-size-fits-all approach. An investor’s risk-taking ability and financial goals should determine the right mix of active and passive funds in his portfolio. Ideally, an investor should consult a financial advisor to get a well-curated portfolio and keep an eye on the returns from the different investments they hold.

If an investor is just starting on his investment journey, going with the wisdom of the masses is a justified choice. In such a situation, Index funds can be a durable solution for his investment needs. If an investor has been in the markets for long, getting some exposure to Index funds can add a much-needed layer of diversification to the fund management style and market capitalisation of their portfolio.

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