How to select an index fund: a step-by-step guide

Published on June 19, 2024 / By M. Pattabiraman Twitter: @pattufreefincal

Published: June 19, 2024 at 6:00 am

Here is a step-by-step guide to selecting an index.

1. Where and how you invest does not matter if you do not have a proper investment plan. The right return expectation, the correct initial asset allocation, an excellent risk-management strategy, systematic investing, systematic increase in investing and periodic reviews. The freefincal robo advisor tool can create such a robust financial plan.

2.  Active or passive investing or a mix of both is a choice. You can choose anything; just don’t be smug and assume your choice is the best. There are multiple solutions to most problems in life, and nothing is perfect. Also, see: What are the risks with index investing? And Active Mutual Funds Outperformance Consistency Report (March 2024).

3. First, we can eliminate ETFs. Their low costs do not matter. ETF investors must buy/sell units from other ETF investors (unless they are super rich and can buy/sell directly from the AMC). This creates an additional risk, especially in volatile conditions. Unless you trade, ETFs are unnecessary. See: ETF or Index Fund? Look beyond low expenses and tracking errors!

4. Understand how market capitalization works! Buying Nifty 500 will not give you 450 additional stocks! It will not give you more of the market (at least not as much as you think). See: Motilal Oswal Nifty 500 Index Fund Fees slashed by 60% – should you invest? And Groww Nifty Total Market Index Fund Review

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5 Stick to a Nifty 50 or Sensex fund. If you can appreciate risks and suffer from FOMO, you can have some small exposure to Nifty Next 50 or buy a Nifty 100 index fund and be done with it. You don’t need anything more! No, you don’t need that mid cap index fund (or active fund), and you don’t need a small cap index fund (or active fund)! See Nifty vs Nifty Next 50 vs Nifty Midcap 150 vs Nifty Smallcap 250: Return Comparison April 2024. Also, see Watch my talk on active vs passive investing in India

6 Recognise that factor indices are subject to data mining risks. See Data Mining in Index Construction: Why Investors need to be cautious. Also see: Why Nifty Midcap150 Quality 50 index performance is a warning for factor investing fans and DSP Nifty Smallcap250 Quality 50 Index Fund Review.

7 With that out of the way, you only have a small list of Nifty, Sensex, Nifty 100 and Nifty Next 50 index funds. How do you further shortlist?

• Ignore expense ratios. They keep changing. See: The expense ratio of my index fund has doubled! Should I switch to ETFs?
• Ignore tracking errors. They are for fund managers, not investors.
• Look for reasonably small tracking differences (fund return minus benchmark returns). You can use our monthly index fund tracking error screener.
• Look for reasonable AUM. At least a 100 plus crores? It is hard to say what is reasonably large.
• That is it. Just pick one and invest!

Also see:

• Watch my talk on active vs passive investing in India
• My 13-year-old begins his investing journey with an index fund