Index Investing – US vs India
Index investing started in the US in the 1970s. Since then, it has grown exponentially in the US and across the globe. In India also, index investing is growing at a fast pace. In this article, we compare index investing – the US vs India. Before we begin, let us first understand what an index fund is.
What is an index fund?
An index fund is a mutual fund scheme that tracks the performance of an index and seeks to replicate its returns. An index fund invests in all the constituents of the index as per their weightage.
For example, in India, an index fund tracking the Nifty 50 index will invest in all the 50 constituents according to their weightage. As of 31st May, Reliance Industries Limited (RIL) had the highest weightage of 10.35%, HDFC Bank had the second-highest weightage of 9.79%, and so on in the Nifty. So, any index fund tracking the Nifty 50 will have to allocate 10.35% of its money in RIL and 9.79% in HDFC Bank.
Similarly, in the US, an index fund tracking the S&P 500 index will invest in all the 500 constituents according to their weightage.
The passive style of investing
An index fund follows a passive style of investing. It purchases all the index constituents as per their weightage and holds them. Thus, no active buying and selling of securities take place. This results in benefits like lower costs, returns, simplicity for new investors, etc., as explained below.
Benefits of investing in an index fund
Some of the benefits of investing in an index fund include:
- Low costs
The cost of investing in an index fund is much lower than that of an active fund. This is because an index fund invests in all the index constituents and holds them. Thus, there is no portfolio churning in the form of regular buying and selling. Also, there is no research to be done by the fund manager to identify which stocks to buy. Due to these factors, the expense ratio of index funds is meagre.
In the US, the expense ratio of many index funds is less than 0.10%. However, in India, the expense ratio of many index funds is up to 0.50%.
Let us assume that before accounting for expense ratio, an active fund and an index fund have given the same returns. After considering the expense ratio, the returns of an index fund will be superior to an active fund due to the low expense ratio.
- Simplicity to new investors
Investing in an index fund is simple for new investors. They get much-needed diversification through a single investment. For example, an index fund in India, replicating the Nifty 50, gives an investor exposure to more than ten sectors. Whereas a US index fund, tracking the S&P 500, provides an investor exposure to all the sectors of the economy
How did index investing start in the US?
Jack Bogle introduced the concept of index investing in the US in 1975 with the establishment of The Vanguard Group. The group launched the Vanguard 500 Index Fund in 1976. It was the world’s first index fund. Since then, the Vanguard Group and other asset management companies have launched many index funds.
Chart: Returns given by Vanguard 500 Index Fund since inception
Passive investing overtakes active investing
Index investing grew from strength to strength in the US. In 2019, it achieved a significant milestone when the assets under management (AUM) of index-based mutual funds were higher than that of active mutual funds for the first time. According to Morningstar, in September 2019, passive US funds had an AUM of $4.27 trillion compared to AUM of $4.25 trillion for active US funds.
Proponents of index funds
“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
Popular indices in the US and index funds benchmarked to them
Depending on the stocks you want to invest in, you can choose from index funds that track the following indices.
|Stocks coverage||Indices||Index Funds|
|Top 500 US stocks covering diverse sectors||S&P 500||Schwab S&P 500 Index Fund, Fidelity 500 Index Fund|
|Large-cap stocks covering technology, consumer services, health care, financial companies, etc.||Nasdaq Composite, Russell 1000 Growth Index||Fidelity Nasdaq Composite Index Fund, Vanguard Growth Index Fund Admiral Shares|
|US mid-cap stocks||S&P MidCap 400 Index, Russell Mid Cap Index||Northern Mid Cap Index, Vanguard Mid Cap Index Admiral Shares|
|US small-cap stocks||Russell 2000 Index, S&P Smallcap 600 Index||Northern Small Cap Index Fund, Schwab Small Cap Index Fund|
|International stocks||MSCI EAFE, MSCI Emerging Markets||Vanguard Total International Stock Index Admiral Shares, Schwab International Index Fund|
|Bonds||Bloomberg Barclays Global Aggregate Bond, Bloomberg Barclays Capital Aggregate US Bond Index||Vanguard Total Bond Index Admiral Shares|
Growth of index investing in the US
With time, it has become increasingly difficult for active fund managers to beat the index in the US. As a result, active funds have constantly been seeing net fund outflows, and passive funds have been seeing net fund inflows from the last few years. According to Morningstar’s data, only 23% of active funds performed better than their rival passive funds in the ten years June 2009 – 2019.
Chart: Share of index funds in the US
As we can see in the above table, in 2010, the share of passive funds in the US was at 20%. In the last ten years, the share of passive funds in the US has climbed to around 40%. In September 2019, the passive funds overtook their active counterparts. By 2025, passive funds are expected to command a 55% market share, leaving 45% to active funds.
Passive investing in India
We saw how passive investing is sprinting ahead of active investing in the US in the earlier section. Similarly, passive investing has started gathering pace in India also.
Passive investing in India started in July 1999 with the IDBI Index INit' 99 Fund. It was followed by the launch of the UTI Nifty Index Fund in March 2000.
Since then, many index funds have been launched in India and have attracted many investor attention.
SEBI guidelines for index funds in India
In India, as per SEBI guidelines, an index fund has to invest a minimum of 95% of its total assets in the securities of a particular index that it is tracking.
Case for index investing in India
Over the years, just like the US active fund managers, the Indian active fund managers are also finding it difficult to beat the benchmark index. At the end of 2020, S&P Global released the SPIVA India Scorecard. This scorecard compared the performance of actively managed mutual funds with comparable broad indices over various periods.
In most cases, the results showed that more than 50% of the active mutual funds underperformed the comparison indices over various periods.
Table: Underperformance of active mutual fund schemes against comparison indices
|Percentage of funds that underperformed comparison index|
|Fund category||Comparison index||1 year (%)||3 year (%)||5 year (%)||10 year (%)|
|Large-cap||S&P BSE 100||80.65||88.14||87.95||68.42|
|ELSS||S&P BSE 200||65.12||90.91||85.71||51.43|
|Mid/small-cap||S&P BSE 400 Mid Small Cap Index||66.67||34.88||54.35||35.71|
|Government bonds||S&P BSE India Government Bond Index||50.00||74.36||76.74||86.00|
|Composite bonds||S&P BSE India Bond Index||90.67||96.53||97.22||96.15|
Note: Data is as of 31st December 2020
As can be seen in the above table:
- More than 80% of the large-cap funds underperformed the S&P BSE 100 Index over one, three, and five-year periods.
- More than 50% of the Equity Linked Savings Schemes (ELSS) underperformed the S&P BSE 200 Index over one, three, five, and ten-year periods.
- The performance of mid and small-cap funds is somewhat better than the S&P BSE 400 Mid Small Cap Index over three and ten-year periods. However, more than 50% of the funds underperformed over one and three-year periods.
- More than 50% of the bond funds underperformed the comparison index.
With such a significant underperformance of active funds compared to the comparison index, the above data makes a strong case for investing in index funds in India.
Penetration of passive funds in India
Index funds, along with Exchange Traded Funds (ETFs), are a part of passive investing. Passive investing has received a lot of acceptance in India in the last few years. As per the data reported by AMFI, the following are the statistics for May 2021.
|Scheme name||No. of schemes||No. of folios||Net inflow for May 2021 (Rs. in crores)||Net AUM as of 31st May 2021 (Rs. in crores)|
|Grand Total for MF Industry||1,597||10,04,36,145||-38,601.87||33,05,659.89|
As seen from the above table, passive investing makes up almost 10% of the overall mutual fund industry. In the future, passive investing is growing fast and is expected to garner a more significant share of the Indian mutual fund industry.
Chart: Growth of passive investing in India
How to choose an index fund
When selecting an index fund, an investor should look at two primary criteria:
- Low costs
When comparing two index funds with the same benchmark index, an investor should consider the one with a lower expense ratio.
- Tracking error
When comparing two index funds with the same benchmark index, an investor should consider the one with a lower tracking error.
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