The year 2021 was full of milestones for the Indian equity market and equity mutual funds. Domestic equity indices across market cap range such as the S&P BSE Sensex, Nifty 50, Nifty Midcap 150, Nifty Smallcap 250, and Nifty 500 scaled record highs during the year and turned out to be the top performers among global peers.
The rally in major equity indices has lured investors to Index Funds. As you may be aware, Index Funds are mutual funds that aim to mimic the performance of a particular index such as Nifty 50, S&P BSE Sensex, S&P BSE 500, etc. Following a passive investment strategy, these funds try to match constituents that form part of the index with an aim to mirror its performance. Therefore, when you invest in an index fund, the scheme’s performance will mimic that of the index.
Though Index Funds have been in existence for many years now, it has caught investors’ attention only in recent years. Factors such as, easing of lockdown restrictions, pick up in most business/industrial activities to pre-COVID levels, growing vaccination drive, and improving consumption trends boosted hopes of economic recovery. Accordingly, a growing number of investors participated in the equity market to benefit from India’s growth story which enabled the equity indices to clock one of the best performance in recent years.
Thus, the sharp rally in the equity market and high participation from retail investors took the AUM of Index Funds to 40,000 crore in November 2021 from around 15,000 crore in January 2021. The number of Index Fund folios more than doubled to 19.4 lakh from 8.7 lakh during the same period.
The underperformance of certain actively managed funds, particularly in the Large-cap Funds segment, also prompted some investors to switch to passively managed schemes such as Index Funds.
Graph 1: Index Fund folio and AUM more than doubled in 2021
Data as of November 30, 2021
(Source: AMFI, PersonalFN Research)
Will the equity market indices continue to rally in 2022?
In the current calendar year, the broader Nifty 500 index has gained around 30% (absolute), while it is up by 140% (absolute) since the lows of March 2020. Mid-cap and small-cap stocks did remarkably well and outpaced their large-cap peers.
However, after a stupendous rally in the last 18-20 months, the valuations in many stocks have run ahead of the fundamentals and look expensive. Moreover, the new variant of COVID-19 has emerged as a key risk that could impact consumer sentiments and business activities in the coming months. Rising inflation trend and normalisation of monetary policy by RBI is another factor that could lead to higher volatility in the equity market.
Therefore, it is likely that the bullish momentum in the equity market will slow down in 2022, and we may witness higher volatility resulting in some correction.
Graph 2: Indian equity market scaled record highs in 2021
Data as on December 30, 2021
(Source: ACE MF, PersonalFN Research)
Equity indices in India and globally have already witnessed some consolidation over the past few weeks due to the threat of the Omicron variant and the announcement of tapering of stimulus by the US Federal Reserve. Consequently, the Nifty 500 index is down by around 6% from its peak.
Despite the recent correction, the valuations in the small and mid-cap space are still more expensive as compared to those in the large caps. This highlights that that the correction in the broader markets may not be over yet. If markets go further down in 2022 from the present levels, which is quite possible, mid and small-cap stocks would be more vulnerable than large-cap stocks.
Does it make sense to invest in Index Funds now?
Since equity market volatility is expected to persist in 2022, the returns from your investments in Index Funds could turn modest. If you get into Index Funds now expecting stellar returns, like the one witnessed in 2021, you could get caught on the wrong foot. Remember that market volatility and correction impacts Index Funds as well.
So if you are looking to invest in Index Funds, do so only if you have a long term investment horizon of at least 3 to 5 years. Opt for the SIP route to invest in Index Funds to mitigate the impact of market volatility and to avoid getting swayed by short term trends.
Index funds provide a low-cost investment offering for investors looking to earn decent returns from equities by tracking the respective benchmark index and/or underlying fund and do not have the appetite for high volatility, making it ideal for new investors who have just started their investment journey. Depending on your risk profile and investment horizon, you can choose from Index Funds that track Nifty 50, Nifty Next 50, Nifty 500, among others. Advisably, you should avoid sector-oriented passive funds if you do not have a very high risk appetite.
Index Funds are also a good option to get exposure to the international markets and diversify your portfolio. In the past few months several fund houses have launched Index Funds that track international markets such as the USA, China, Europe, etc.
And when you invest in passively managed funds, prefer the one with low tracking error so that the performance of the fund does not deviate much from the index.
That said, if your strategy is to get alpha-generating returns, passive funds may not be the right option for you. Therefore, investors with moderate to high risk profile should consider investing in actively managed mutual funds or a mix of passively managed funds and actively managed funds.
If the market corrects from the current level, it will provide active fund managers the opportunity to pick quality stocks at reasonable valuations. This is especially true for the mid-cap and small-cap segment where actively managed funds have a better scope of generating high alpha in the long run by identifying stocks with high growth potential. Passively managed funds like Index Funds do not have the flexibility to align their portfolio in line with the dynamic market conditions.
India’s long term growth story appears intact which bodes well for equity mutual fund investors provided they follow a disciplined approach to investment.
Ensure that you select the best and the most suitable mutual fund schemes for your portfolio after evaluating it on quantitative and qualitative parameters and not based on recent performance. And lastly, avoid investing in too many schemes as it can make it difficult to monitor its performance and eliminate the laggards.
This article first appeared on PersonalFN here