An index fund in the form of a direct plan is the best way to invest if you want a reliable way to invest. The index fund helps buy a basket of 50 stocks (Nifty index fund; there are other index funds too tracking the Next 50 in Nifty, Midcap Index, etc) at a very low cost.
The direct plan of the index fund reduces your expense ratio further. So these are the very good benefits of investing in an index fund. The third one is that there is no risk of the fund manager not performing well, or not aligned to your interest.
Is the Index Fund Better or an Actively Managed Mutual Fund?
Just by mirroring the index, index funds have outperformed most large-cap funds. If you open the portfolios of most mutual funds, you will see that they hold many index stocks. This is called closet-index hugging. Many funds exhibit this pattern and you can spot them by checking their performance track record. If they are consistently above or below the index by 1 or 2% and are holding 20% more funds that the index then chances are they are closet index funds.
This is not a good thing for you because you are paying a higher expense ratio for a not-great performance. Net of expense ratio you are not making more than the index itself. Why not simply buy the index itself as an index fund (or an Exchange Traded Fund or ETF)?
How do I select an Index Fund?
Simply go for a reputed fund house and a fund that has the least deviation from the index performance. This deviation is called the tracking error. Also, go for a fund with the least expense ratio because a passive fund must have lower costs.
Anything wrong with Index Funds as an Investment Strategy?
Nothing major, expect that a fast-growing company may take time to enter the index; much of its growth momentum may be ‘lost’ after it enters the index unless of course, it is a blockbuster company and the next Amazon of the world. Similarly, if a company declines, it may linger in the index for a long time before getting ejected. In both cases, you may not gain majorly as an investor.
Also, note that volumes in index funds and ETFs grow, the herd money rushes into a common territory. This is actually not a bad thing for the average investor, but the discerning investor may not be able to tap the great value that gets created outside the index.
Is there a better investment strategy?
A direct equity portfolio if managed well works better because of the above structural issues in how index funds work. This increases risk but the rewards can be much higher. Also if the investment strategy mitigates risk then you may consider it.
The Roots & Wings investment philosophy of Jama Wealth is one such example. It is a quantitative methodology that has been enhanced with machine learning.
The ‘Wings’ are growth-focused (sales, profit, op income) and ‘Roots’ focus on key ratios and promoter values. The portfolio style is to preserve and grow; via large-midcap companies (no small/micro caps).
The model is clean because the equity advisor doesn’t touch client money and they don’t take custody of stocks. There is no lock-in, no exit loads, and hence no conflict of interest.
This portfolio has returned about 34.05% in the last one year vs Nifty Total Returns Index at 5.11%. The long term average rolling 3-year return measured over the last 13 years (ie 52 observations) is 27.73% vs Nifty Total Returns Index 11.09%.
For the average investor, direct index funds are a good vehicle to start compounding wealth. For those who moved up to the next level, a direct equity portfolio would make better sense.