How to pick the best index/passive mutual fund?

How to pick the best index/passive mutual fund? | Vrid
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We discussed picking direct plans of mutual funds over regular and selecting active and passive mutual funds across categories here and here.

And now, we move to the next crucial question. How to analyse and compare different mutual funds and pick the best one?

In this blog, we will dive deep into the essential metrics to look for before selecting a passive mutual fund to invest in.

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From past blogs, a few things have been crystal clear. 

  • You should only invest in direct plans of mutual funds
  • In the large-cap category, passive/index funds performed better
  • In the mid & small-cap categories, some active funds have outperformed passive funds

Now, there are many funds available in each category, and there are some metrics that are essential over others. Let’s discuss these important metrics.

Important metrics in passive/index mutual funds

A quick explanation of passive funds, these funds try to replicate the index benchmarks like Nifty 50, Sensex 30, Nifty Bank, etc. They try to match the performance of the market and never try to outperform. 

Passive funds have a low expense ratio compared to active funds. And as explained in this blog, most active funds have failed to outperform the market in the long term. So, passive/index funds are considered as best investments by some, as they have lower expense ratios and match the performance of the market to some extent. Warren Buffett is a big promoter of index funds.

And if you have decided to invest in passive funds, you need to look for –

1. Tracking error

Remember when you tried to look out and copy your friend’s answer sheet in the exam hall? If you were able to copy the exact answer 100%, you are a genius.

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Now, as you know, a passive fund manager tries to replicate the index benchmark. They often miss out on something. It may be the timing of investment or maintaining cash in the fund to handle redemption. There is a small tracking error here and there. 

So when you are comparing some index funds, check for index funds with low tracking error. An index fund with a higher tracking error can offer lower returns than the market benchmark.

2. Expense ratio

Every fund has a team of managers and analysts to pay for. So every fund collects this cost from their client, which is you. They collect this expense as management fees. 

Not going deep into it. All you need to know is these expenses are shown as expense ratio in annualised terms. They already deducted the expense ratio from the returns of the funds. That is if a fund has an expense ratio of 1% and the return shown is 12%. Then the actual return of the fund is 13%.

Mutual fund companies always show the fund returns after deducting the expense ratio. Comparing expense ratios of different funds lets us know how different mutual fund companies (AMC) are managing their funds. 

A lower expense ratio achieved by an AMC can lead to better returns compared with other funds with a higher expense ratio.

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3. Asset under management (AUM)

While analysing tracking error and expense ratio is the most essential part. Often people forget to check the AUM or the history of a manager, or the fund.

As index funds demand is increasing, AMCs are launching a bunch of new funds. So the index fund must have an AUM of over ₹500 or ₹1,000 crores. Also, it is better if the fund is more than 3 to 5 years old. 

These give us an idea of how old the fund is, and how the manager has performed over the years. For example, if an AMC launched a fund just last year and has a very low tracking error compared with others, this doesn’t guarantee that this fund will have a low tracking error in future too. 

Important points to remember

  • Compare apple to apple and not apple to an orange. That is, compare a Nifty 50 index fund with another Nifty 50 and not with a mid-cap or small cap index.
  • Don’t fall for low NAV or unit price. Lower NAV doesn’t guarantee higher returns possibility. 
  • You can also invest in mutual funds directly with AMCs without a Demat account. 
  • Index funds are not risk-free investments. A large-cap fund or Nifty 50 is the safest compared to other indexes, as they have blue-chip stocks. As you go beyond it in Nifty Next 50, Mid-cap 250, etc. the risk keeps increasing.
  • Additional risk doesn’t always generate additional returns.
  • Don’t forget to harvest tax from long-term gains in equity investments. 

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Still Curious?

If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.

India ETFs – List of Index Funds

ET Money – How To Select The Best Index Fund?

ET Money – Index Funds v/s ETFs | Should You Invest in ETFs or Index Funds? | Passive Investing

Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.

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DISCLAIMER: This newsletter is strictly educational and is not an investment advice or a proposal to buy or sell any assets. Please be careful and do your own research.

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