« Can debt funds beat inflation? How to switch from regular to direct funds? »

Are index funds less risky than active funds?

10 Dec 2021 - Contact Sayan Sircar

Tags: Portfolio Construction ; Risk

5 mins read

Understanding the risk of every asset class in our portfolio is essential. This article talks about the risk in index funds.

Are index funds less risky than active funds?

Introduction
Sources of risk in equity investing
Risk in mutual fund portfolios
Investor risk in mutual fund investing

Introduction

Index funds are created using a written down formula or method that does not involve any active decision making by the fund manager. Many investors interpret this as index funds are lower risk than active funds. We will examine if that belief is true.

An investor looking for a primer on index fund investing should read this post first: Which index funds to invest in and why?

Recent articles:

1 / 3

<p>This article shows a way to decide what to do when stock markets reach all-time or lifetime highs. Should investors buy more or sell to book profits?</p>

The stock market has reached an all-time high. Should you buy or sell?

2 / 3

<p>This article uses the Arthgyaan Have vs Needs Framework to invest a large lump sum amount in your portfolio per your financial goals.</p>

How to invest a lump sum amount for your goals?

3 / 3

<p>This article shows you how the concept of indexation lowers the capital gains tax you pay when you sell debt mutual funds.</p>

Pay lower capital gains taxes for debt mutual funds: understand how indexation works

❮ ❯

Sources of risk in equity investing

Risk comes from multiple sources when investing in the stock markets. These are:

stock-specific risk or unsystematic risk
market-specific risk or unsystematic risk

Type of risk

Stock-specific risk or unsystematic risk is inherent to a single company. Decisions taken by the management, perception of customers and shareholders and overall market sentiment contribute to stock-specific risk. For example, the ethical perception of the Tata Group, the premium perception of Apple products and the rocket-like trajectory of Tesla are all examples of stock-specific sentiment or risk. In addition, stock-specific risk affects a single company in a sector. For instance, the Satyam scandal led to the stock price crash of Satyam but not that of other IT companies at the same time. Similarly, there is sector-specific unsystematic risk. For example, COVID impacted the hospitality and travel sectors badly, but the technology sector benefited greatly.

To lower the impact of unsystematic risk, the investor must invest both in multiple stocks in the same sector and different sectors in the same economy.

However, you cannot lower total portfolio risk indefinitely by adding more and more stocks. This is because some factors impact the overall country’s stock market that moves all stocks. After all stock-specific risk is eliminated, the residual risk is systematic risk. Examples of systematic risks are global fund flows, GDP growth rate, inflation and interest rates.

Inflation: the impact on your goals and how to choose assets that beat it

For example, fund flows from foreign investors are an essential factor that affects the entire Indian stock market and events like the 2008 Global Financial Crisis and the 2020 COVID Pandemic led to falls in stock markets globally.

To lower the impact of country-specific risk, investors should diversify their portfolios by investing in global stocks.

Risk in mutual fund portfolios

Source of risk in mutual fund portfolios:

active mutual funds: fund manager risk, stock-specific risk, market-specific risk
index mutual funds: stock-specific risk, market-specific risk

Mutual funds are a portfolio of multiple stocks and have lower unsystematic risk than individual stocks.

An active fund manager is supposed to beat the index by:

choosing which stocks to buy and sell
constructing a portfolio “sufficiently” different from the index to get alpha
choosing how and when to time purchases and sells

By replicating a rule-based index, index funds take the diversification benefits of active funds and remove fund manager risk altogether.

Risk of funds

The impact of fund manager risk is shown in the figure above. This is a snapshot of active large-cap mutual fund and index fund risk from Valueresearchonline. We see that risk in index funds is in a narrow band and is not necessarily lower than that of active funds. On the other hand, active funds have managed to have total risk lower and higher than index funds. The the diagram, we have singled out large-cap market capitalization weighted Index funds tracking the Nifty 50 and Sensex specifically under the index fund definition.

Another interpretation of this diagram strengthens the premise of index funds having lower risk than active funds. The risk of index funds is within a narrow band, which is predictable, unlike active funds.

Investor risk in mutual fund investing

We have described active decision making by fund managers for their funds as a source of risk. Similarly, investors introduce an element of active risk in creating and managing their portfolios by

chasing returns based on past performance
moving in and out of funds without proper due diligence
investing in multiple funds in the same category that increases the overall cost
cluttered portfolios that require active maintenance and high tax impact

On a portfolio level, active decision-making can be curtailed if there are only index funds. In such a portfolio, the only decision to be made is when to rebalance. All other times, the investment can continue into equity funds as per the asset allocation. In addition, active fund investors have an additional step of evaluating the performance of each active fund in their portfolio.

Factor based index funds like funds tracking the Nifty Next 50 index or other value, volatility or alpha based indices are not considered in the diagram to be index funds due to their risk profile being influenced by the factor used in the construction. An investor who is investing in such funds will have to keep in mind that the risk profile, though different from active fund manager risk, will be different. The tracking needed to manage this risk profile will fall under the investor’s own tracking risk.

In summary,

moving from stocks to active funds to index funds reduces risk
however, the market risk remains
Proper asset allocation is needed always
Market risk needs to be managed via review/rebalancing

Worked out case studies for goal-based investing

Case study: how this double income recently married family can perform DIY goal-based investment planning

This article shows how a young just-married couple can invest for future goals using the Arthgyaan goal-based investing tool.
Case Study: How should couples in their 40s with a new baby plan their financial future?

Did you welcome a bundle of joy in your 40s? This article will discuss ways of planning the child’s (and your’s financial future)
Case study: how this double income single kid family can perform DIY goal-based investment planning

This article shows how a very typical salaried couple with one child can invest for future goals using the Arthgyaan goal-based investing tool.

Previous and next articles:

<p>Many investors have a need where they want the safety of assured returns and wish to beat inflation simultaneously. Can debt funds do that?</p>

Portfolio Construction

Can debt funds beat inflation?

Many investors have a need where they want the safety of assured returns and wish to beat inflation simultaneously. Can debt funds do that?

Published: 9 December 2021

10 MIN READ

<p>Investors who have investments in Regular mutual funds should switch to Direct. This post explains how.</p>

Portfolio Review

How to switch from regular to direct funds?

Investors who have investments in Regular mutual funds should switch to Direct. This post explains how.

Published: 11 December 2021

7 MIN READ

Latest articles:

<p>This article shows the effect of postponing early retirement by just a little since it allows you to spend more in retirement.</p>

FIRE

FIRE journey in India: what happens if you work just a bit longer

This article shows the effect of postponing early retirement by just a little since it allows you to spend more in retirement.

Published: 4 December 2022

2 MIN READ

Market Movements

The stock market has reached an all-time high. Should you buy or sell?

This article shows a way to decide what to do when stock markets reach all-time or lifetime highs. Should investors buy more or sell to book profits?

Published: 30 November 2022

4 MIN READ

Topics you will like:

Asset Allocation (17) Basics (8) Behaviour (10) Budgeting (9) Calculator (13) Case Study (3) Children (9) Choosing Investments (28) FAQ (3) FIRE (10) Gold (6) Health Insurance (4) House Purchase (13) Insurance (12) International Investing (8) Life Stages (2) Loans (10) Market Movements (8) Mutual Funds (14) NPS (5) NRI (4) News (5) Pension (6) Portfolio Construction (36) Portfolio Review (22) Retirement (29) Review (7) Risk (6) Safe Withdrawal Rate (5) Set Goals (26) Step by step (8) Tax (16)

Next steps:

1. Email me with any questions.

2. Use our goal-based investing template to prepare a financial plan for yourself
OR
use this quick and fast online calculator to find out the SIP amount and asset allocation for your goals.

Don't forget to share this article on WhatsApp or Twitter or post this to Facebook.

Discuss this post with us via Facebook or get regular bite-sized updates on Twitter.

Arthgyaan

Supporting everyone's personal finance journey