In our last article we discussed how index investing helps investors in solving the problem of poor stock selections. Click here if you want to have a look at it. Index investing has more advantages than just getting rid of lousy stock selection. In this article we will try to brief some more pros of index investing which makes it a better choice for the investors.

Lower Cost

There is a cost involved for investing or trading in the stock market. This cost may be in the form of brokerages or taxes that an investor or trader has to pay. The more actively managed funds would have a greater number of transactions and hence more will be the costs involved.

If we invest in a fund which is actively managed, there will be a management fee associated with it. It is called the expense ratio. Although the expense ratio could be as low as 1% and seems less yet it could have significant impact on your investments in the long run. Let us understand with the help of an example.

On the left-hand side table, a lumpsum investment of Rs.50,000 at the rate of 8% will grow to Rs.2,33,048 at the end of 20 years. On the right-hand side table, we have same investments at same rate for the same time. But there is an expense of 1% per annum charged on this investment. The difference is clearly visible, see the right-hand corner of the table. At the end of 20 years, net capital will be 1,88,705 which is 19% less than the one with no expense ratio.

Index funds are passively managed, so the costs involved in these funds are relatively less. Investors can buy ETFs right away from their broker’s terminals and that’s it. Besides standard brokerage and taxes on initial investment, there are no other annual expenses that investors need to incur.

Diversification

If you concentrate all your financial resources at one place, there would be a danger of losing everything if it turns out to be a bad investment. Even a good index stock may turn out to be a bad performer in the coming years. And who knows, may be within next few years, it may slip out of the index as it may lose investors’ interest for various reasons.

Just imagine two fruit baskets. One is full of oranges while the other with variety of fruits ranging from grapes, apples, oranges, pomegranate, guava etc. Which basket will be more nutritious for your body? You know the answer. In similar way, your portfolio should be a mix of the best stocks so as to generate fruitful results for you in the long run.

Diversification is a term opposite to homogeneity. In financial terms, diversification means distributing your investments in not just one stock or one sector, but in the best from all the sectors. Sadly searching and analyzing for the best could be tedious task. This problem can be easily solved with index funds or ETFs. These funds not only replicate and generate returns equivalent to the indices they represent, but they also offer much-needed diversification to our portfolios.

Not only that, the investors need not to worry about the weightage of the stocks in their portfolio. If a stock has acquired more weightage and another one has lost some weightage in the indices, the same would be automatically adjusted in the index fund or ETF itself. In other words, a good company would automatically overweight a bad one through this mode of investment.

International Investments

No doubt India is one of the world’s fastest growing economies yet its GDP is just a single digit percentage points of the gross world’s GDP. Which means that investors can still reap the benefit of more than 95% of the world’s GDP through international investments.

This situation is also like ‘don’t put all your eggs in the same basket’, but in a macro sense. If you would have all your investments in one country and that country has been going through a tough phase due to various geo-politico-economic reasons, then you may have to suffer losses until that country comes out of its slowdown phase. In order to mitigate this problem, the investors can reap the benefit of investment opportunities available outside India. In this way investors can diversify the risk involved in a single country.

Investors can either opt for actively managed domestic mutual funds or passive Global Exchange Traded Funds (Global ETFs) for international investments. Global ETFs allow domestic investors to take exposure in international indices. These ETFs trade on the cash market segment of NSE and can be traded just like the stock of any other company listed on the exchange.

One more advantage of this domestic mode is that you are investing in Indian currency. There is no need to first convert into dollars or any other currency before investing.

Another advantage would be that in case of depreciation in rupee (INR), the international investments made through Global ETFs will generate higher returns in terms of INR. Therefore, the rupee depreciation will be hedged through these investments.

There are a few Global ETFs listed on the Stock Exchanges in India.

There is Motilal Oswal NASDAQ 100 ETF which represents the top 100 technology companies of USA, comprised in NASDAQ100 index. By investing in this ETF, you will be availing the opportunities in those top tech companies of USA.

Similarly, there is Hang Seng Bees. The 50 constituent companies of Hang Seng represent 58% of the market capitalization of Hong Kong Stock Exchange. Thus, by investing in Hang Seng Bees, you are actually investing in the top 60% listed companies of Hongkong.