Many investors who have missed the stock market rally from Covid lows have been waiting on the sidelines for a correction, so that they can enter equity funds for the first time or add a higher equity allocation in their portfolios. Any correction triggered by coalition politics, after the National Democratic Alliance (NDA) won a much slimmer majority than expected, may offer such opportunities in the coming days.

But buying when there’s blood on the screen is easier said than done. When the market launches into a correction after a long bull phase, panic lows can happen in the blink of an eye. These falls, usually accompanied by wild intra-day gyrations, allow little time for investors to make considered choices on which stocks to buy or do their due diligence on individual stocks.

If capitalising on a correction is your main objective, it is not necessary to buy individual stocks. Buying passive mutual funds, which simply mirror the basket of stocks making up an index, can work equally well or even better.

Index funds vs ETFs

Passive funds can take two forms. One option is to buy exchange traded funds (ETFs) which are traded on the stock exchanges — you need a demat account and can buy them at traded prices. Or they can take the form of open-end index funds, where you buy units at the latest Net Asset Value (NAV) from the fund house. Of the two, open-end index funds are a better option for long-term investors.

Most ETFs in India are not highly liquid, resulting in their market prices moving way off their NAVs, especially on days when buying or selling spikes. During the correction on June 4 for instance, even relatively actively-traded ETFs such as Nippon Bank BeES traded at significant premiums to the underlying NAV, while many others lacked liquidity for timely trades. With open-end index funds, investors can avail of same-day NAVs by placing orders before the specified cut-off times.

Why index funds

Taking the index fund route to participating in corrections offers three distinct advantages over buying individual stocks.

Simplifies choices: Usually, when long bull markets reverse, the set of sectors or stocks that leads the new bull phase are quite different from those that were market favourites before. Currently for instance, it is unclear if PSUs or other “Modi” themed stocks will lead the rally once the new government is in place. Picking the wrong stocks in panic phases can leave you holding losses or prevent you from participating in the rebound when it materialises. Index funds, which own a basket of bellwether stocks, can simplify your choices, and ensure you participate in any rebound.

Allows quick action: When buying during a panic fall, quick execution wins the day. Snapping up funds or ETFs is much easier than deciding on the right prices and quantities of individual stocks to buy. Getting the individual position sizes wrong can also lead to poor upside participation. With an index fund or ETF, the weights of stocks in the baskets are pre-decided. You only need to make a call on buying two-three funds and weights to them.

Changing basket: When you buy an index fund or ETF, you do not need to churn your portfolio later to weed out underperformers or replace them. The stocks in the fund automatically get changed as the index provider replaces them. As most indices in India include or exclude stocks based on their market capitalisation, index funds and ETFs automatically weed out underperformers and add weights to outperformers over time.

Therefore, in the event of a market correction, what are the open-end equity index funds that you can consider?

In the current market context, the large-cap segment of the Indian market seems to offer better value than the mid-cap or small-cap segments. Large-caps are also likely to be the first port of call for foreign portfolio investors seeking to rebuild India positions. The index fund options in the large-cap space are restricted to funds tracking the Nifty50, Sensex30 and Nifty100 indices. A rolling return analysis for five-year holding periods for the past decade, shows that both Nifty50 and Sensex30 fare better than the Nifty100 on average returns and the number of periods where they’ve managed a CAGR of 12 per cent or more, with the Sensex30 enjoying a slight edge. Investors choosing specific funds within these categories should look for a track record and competitive expense ratios of sub-30 basis points.

The mid-cap segment of the market currently trades at a premium to large-caps and is thus expensive by historical standards. Investors wishing to take exposure to this segment, for its higher return potential may need to stretch their holding period to 7-10 years, or phase out their investments in these funds. Though there are several mid-cap tracking indices, the ones with a sizeable number of passive funds are the Nifty Midcap150 index and the Nifty Next 50 (also known as Junior Nifty) index. Between the two, a rolling return analysis for five-year periods shows the Nifty Midcap150 faring much better on average returns as well as number of periods with 12 per cent plus CAGR. Investors can choose open-end funds tracking this index with a five-year plus record and an expense ratio of less than 30 basis points.

For investors wishing to play the small-cap segment, active funds remain a better option than passive funds currently. Though a few passive options have emerged in this space, their track record on outperforming active funds and tracking error relative to their benchmarks need to be tracked before investments can be considered.

Related Topics