Index Funds: Learn Investing, The Warren Buffet way

All about Index Funds Investments.

As I told earlier, I didn’t saved anything in 5 years of my job.

When I got up from deep sleep of financial ignorance, I tried to learn everything which I ignored for all these years.

I started reading more and more about it, and somewhere found investments which match my preferences and don’t need to check BSE Sensex and/or Nifty all day.

I was happy that my search for long term investments ended on Mutual Funds, then got to know about Index Funds.

The more I researched on Index Funds, the more I got inclined towards them.

Here, we will get everything you need to know about Index Funds.

Index Funds: Learn Investing, The Warren Buffet way
Index Funds: Learn Investing, The Warren Buffet way

What are Index Funds?

Index Funds are special kind of mutual funds whose portfolio matches the stocks of  benchmark index in terms of listing of companies and proportionate weights.

For e.g. UTI Nifty Index Fund follow Nifty 50 Index , have portfolio with all 50 companies of Nifty 50 and in equivalent proportion as Nifty 50 Index.

The discretion of fund manager is completely eliminated. Due to which Index Funds has lower expense ratio.

Since, benchmark index portfolio is not changed very frequently, so do the portfolio of index funds, the turn around ratio of Index Funds is quite low.

How Index Funds are different from Mutual Funds?

Index Funds and Mutual Funds differs in mandate of portfolio creation. In Mutual Funds, its the fund manager who put in all his sweat (efforts) to find out winning stocks to get better returns on investments.

Whereas, in Index Fund, fund manager is kind of dummy in portfolio creation and fund management. Returns of Index Funds are returns of Index itself.

Index Funds are managed passively. Fund Manager have no control on selecting basket of stocks.

Advantage of Active Mutual Fund

Investing in Actively Managed Mutual Fund is like driving in a UBER cab. You, should know your destination i.e. investment goal (with Index Fund too), and then trust cab driver to take you there.

It then depends on driving skills for driver how fast and safely he will get you there.

There is no doubt Fund Managers spend lot of time and energy in finding stocks which provide Alpha over benchmark index, but, consumer like you and me pay them for that in terms of expense ration.

Point to remember is  there is no co-relation between the expense ratio and returns.

In actively managed fund, its the fund manager who can sink or swim your returns.

The most important aspect of actively managed fund is, it provides some kind of downward protection i.e. in volatile market conditions, Index fund being a puppet of index, will follow it blindly whereas, actively managed funds, provide downward protection by limiting deviation.

Disadvantage of Active Fund Manager

With no knowledge, I started by investing  by filtering funds on value research and money control. For me funds star ratings was the selection criteria.

The Beginners luck didn’t favored me.

Before the recent fall,

During investment period, market had climbed 6000 points

then also my investments were in red.

Should I blame my fund managers or selection of Mutual Funds,

I kept searching for my beta i.e. downside protection and alpha i.e. better returns than benchmark index.

Later realized its was my selection bias and ignorance of fine print

Mutual Fund investments are subject to market risk. Please read the offer document carefully before investing

I didn’t checked the funds expense ratio, turn around ratio , funds  deviation, funds performance in good and bad times, who was the fund manager, fund managers past record, fund’s history, AUM, portfolio stocks and hell lot of noise around Mutual Funds selection.

Also, its not always possible for a portfolio to beat benchmark index again and again in long run.

So, Mutual Funds selection turned to be a monster job for me.

 

 

Warren Buffet Quote on Index Funds
Warren Buffet Quote on Index Funds

What Index Funds did to me?

I came to know about Index Funds.  I tried my hands on it.

Index Funds, gave me simplicity and kept me away from noise.

Index Funds with low expense ratio and loosely coupled with fund managers efforts started giving me peace.

Now, I dont have to track NAV of my mutual fund, I know if Sensex/Nifty has risen, my fund will rise and if its fallen, my fund will fall.

No, downside protection, no looking for alpha.

Simple investing and spending my time on other important activities.

Returns from Index Funds:

Returns from index funds are same as returns of index adjusted for tracking errors and expense ratio.

Index Funds Returns cannot be higher than returns of Index itself.

If economy slows, the companies will start slowing down and even the most carefully managed fund may give negative returns.

Diversification…Yes you heard it right.

As soon as I start investing, elders and experienced, all came in flock and suggested, diversification of portfolio.

I took it seriously,

soon to realize that I over diversified.

As Index is barometer of economy, and composed of companies with high market capitalization from different sectors. So, if banking and financial sector performs bad, pharma may give me support to swim, if pharma also goes down, then IT industry may save me from sinking.

So, diversification helps in risk mitigation and tackling volatility.

I did, can you do??

I invest in Index Funds, you can also do it.

But with caution.

Enter this arena with long term view of 10-15 years.

10-15 years of discipline and control, invest continuously, if India’s economy rise, your investment would too rise.

Why Index Funds are not part of growth story?

I was reading a article, about relevance of index funds in Indian scenario. Where author, quoted that, Indian markets are not efficient market. The barometers of economy i.e. Sensex and Nifty still dont reflect  true picture of our economy. So,  active fund managers are able to beat the benchmarks.

Once our markets becomes efficient like markets of developed countries, it would be tough for actively managed funds to beat the index.

Another reason is awareness and mis-selling. Expense Ration of index funds are very low, and mutual fund advisers did not get great incentive on selling Index Funds.

There are people, who only invest through advisers in Regular plans just to get relived from pain of selecting mutual funds, tracking them and shouldering responsibility to take a exit call. They don’t understand how market works, infact they don’t want to understand the whole noisy thing. As a result, there  are more and more DIY (Do It Yourself) investors investing in Index Funds.

Keep in Mind…!!  Criteria to Select Index Fund

While investing in Index Funds, most important things to keep in mind are:

a. Index Funds invests in pre-defined basket, so it does not have in-built risk management or downside protection. Downside risk should be managed by yourself only. In actively managed funds, downside risk is managed by fund manager.

b. Since, Index Funds have pre defined stocks, and no flexibility to change basket, a bad performer would remain in Index portfolio till it is not removed from Index itself. Similar is the case with a good performing stock. It cannot be included in Index Fund, till its included in Index itself.

c. While there is all good about index funds. Important parameters to look after while selecting Index Funds are Tracking Error and Expense Ratio.

Ideally, investments should me made in fund with lower Tracking Error and lower Expense Ratio.

Conclusion

To a no nothing investor, who don’t understands market and risks associated with it. Warren Buffet recommends investing in Index Funds due to simplicity. You just have to invest and remain invested in them for long term.  In long term index funds a would be able to beat actively managed funds, if India’s market becomes efficient as markets of developed countries.

With returns similar to that index, so investing in them is simplest and cheapest way to get fair share of economic growth over a long term period.

Finally leaving you here with a inspiring quote for no-nothing investor from Warren Buffet…

Warren Buffet on Index Funds
Warren Buffet on Index Funds for No Nothing Investor

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