In investing, every little quirk can be explained with an analogy drawn from cricket. It would be perfectly normal, therefore, to brand passive investing as a leisurely test match spread over several days, and active investing as a high-energy T-20 match complete with sudden bursts of excitement every now and then. The former, typically discharged by mirroring an index, attempts not to beat the market, while the latter is all about outperforming it by as wide a margin as possible.

That said, passive investing seems to be set for an exponential growth in India. Indexing has already drawn the attention of new investors and various market intermediaries are working out smarter ways to introduce index-based investing.

Asset management companies, for instance, are really in a position to steer the trend — so much so that every fourth draft offer document for mutual funds, as released by Sebi these days, draws its core strength from one index or another.

That brings a critical issue to the fore: the emerging diversity in the realm of index funds, aided by multiple indices, including new-generation ones, which blunts the edge of the traditionally popular benchmarks, the Sensex and the Nifty.

Before we proceed, let’s assure ourselves that such diversity is quite healthy for the markets. Use of assorted indices is completely welcome as these help propagate brasher and smarter styles of asset allocation.

No more mere plain-vanilla for newer sections of the investing populace; let the current generation know more about index-based strategies than the older lot. Incidentally, there is already far greater awareness of ETFs (exchange-traded funds) than before.

The point, however, we wish to make is simple. Not every index is suitable for an investor. In a scenario marked by an ever-expanding range of indices, there would be a variety of choices on the table.

The average investor, therefore, must choose carefully. His selection must be based on his needs. The match must be as perfect as possible — else, chances of under-performance would be higher and his ability to achieve his investment goals would be undermined.

Choose well

Asset allocation must be viewed as a function of risk appetite. A discerning investor would be aware of the realities he faces. There would be many opportunities, limitations, challenges for him; the investment products he selects would also be spurred by his risk profile.

Products based on certain indices, therefore, would be more welcome than others. From a basket of nearly comparable index products, he would invariably choose a few, hesitate a bit about others and absolutely avoid some of them.

In the early days, when the idea of index funds was still nascent in India, life was considerably simpler as the choice was essentially between the Nifty and the Sensex. That was then, and it just isn’t so right now. Indeed, there is a great diversity of options. Even thematic/sectoral indices are being taken up by fund houses. Gold ETFs have earned their reputation already. The pie is set to grow larger with the rollout of newer ETFs.

The Indian index fund/ETF story is indeed being played out well and it can be argued that the domestic market is drawing lessons from the western world, including the US platform for indices. The latter has seen phenomenal growth in the last two decades, and players such as State Street, Vanguard and Fidelity are household names today. The popular S&P 500 is among the most well-known indices for the investing fraternity.

Cut to India, investors must remember the following points:

• Not all sorts of indices would be suited to your needs. Keep a leading benchmark (say, Nifty) at the core of your index allocation. This may absorb the bulk of your allocation, say 75 per cent. The others, including newer and more exotic ones, can account for the remaining 25 per cent.
• Indexing does not eliminate risk, although there is overwhelming evidence that passive strategies have beaten active ones over certain stretches of time. A fund that mirrors a rapidly declining BSE 100 would, for example, destroy value for its unitholders.
• Look out for index funds that have low tracking errors. Tracking error can be broadly defined as the difference between returns delivered by an index and that provided by a fund that mirrors its performance.
• Keep an eye on data issued by the stock exchange when it comes to monitoring your ETF. As an investor you need to be familiar with its trading volumes, which would give you a fair idea of the interest generated by the market.

While indexing is a late starter in India, it is not for nothing that the concept has acquired its present day elevated status. An index fund, an extremely low-cost option, can capture the entire essence of the market (or its chosen universe) at one stroke. Diversification is instantly achieved if the preferred index is a broad-based one. A discerning investor would be able to appreciate the idea and use it to his/her advantage.

The writer is director, Wishlist Capital Advisors