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I am a fan of index investing with a buy-and-hold-forever approach in low-cost index funds in the US market. I want to start investing in India. I found that the Indian stock market does not have an index such as the S&P 500 in the US. In the absence of such an index, how can I replicate a similar investing style in India?

I am looking for a fund with the promise of sustained long-term growth, rather than past performance. It must have a low expense ratio and must reinvest dividends for compounded growth. It must be tax-efficient and cover a broad portfolio of companies and sectors beyond the Nifty 50. I am looking at an investment horizon of 20 years and more.

Prashant N

The Indian stock market does have an equivalent of the S&P 500 in the US. There are two indices — the S&P BSE 500 index and the Nifty 500 index — both of which capture the movements of the top 500 companies in the listed universe, based on free-float market capitalisation. There is also an ETF, ICICI Prudential BSE 500 ETF, launched just last year, which passively tracks the BSE 500 index.

However, when trying to replicate the US strategy of index investing in India, you need to bear three things in mind.

One, given that stock market liquidity in India drops off quite sharply beyond the top 150 actively-traded stocks, fund houses usually find it difficult to manage index products that own a broader basket of stocks. The reason why most AMCs in India offer only Nifty 50 or Nifty Next 50 ETFs and index funds is that managing passive funds that track stocks beyond the top 100 can be quite difficult. Passive managers trying to sell or buy stocks beyond the top 150 typically incur high impact costs, which aggravates their tracking error relative to the index.

Two, passive products globally are preferred for their low turnover, but in India, the composition of the stock indices is reshuffled quite frequently. Some passive funds, therefore, tend to feature high turnovers and carry the associated costs, too.

Three, you need to keep the composition of the index you’re tracking in mind while buying index funds for the long term. Recently, for example, the Nifty 50 was criticised for holding a 37 per cent weight in financial stocks and featuring over a 10 per cent weight in its top constituents, both of which enhance portfolio concentration for investors passively tracking it.

Active managers often manage to curtail such risk through lower concentration in sectors and stocks.

However, despite these shortcomings, index investing does offer a good option for the long-term investor who is looking to simply buy and hold his investments at very low management fees that enhance your returns. Choosing an active fund that can outperform the market over the long run is quite a tricky task.

ETFs offer index tracking at much lower costs (even as low as 0.07 per cent). But our view is that open-end index funds offered by AMCs offer a better deal to Indian investors as they allow transactions at NAV and reduce distortions caused by market prices or liquidity issues in ETFs.

If you are keen on index investing, we suggest that you start by starting equal SIPs in Nifty 50 and Nifty Next 50 (open-end) index funds which can help you track the basket of the top 100 stocks in the market. These are typically available at annual expense ratios of 0.10 to 0.50 per cent. Alternatively, you can also explore Nifty 100 index funds. If minimising portfolio concentration is your goal, you can opt for equal weight funds that track the same indices. But such funds do carry the risk of underperforming their base market-cap weighted indices. You can invest in the ICICI Pru BSE 500 ETF after monitoring its actual performance as well as tracking error vis-à-vis the index, for six months.

Send your queries to mf@thehindu.co.in

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