Q. I am a senior jewellery designer working with a jewellery house in Jaipur. I have observed that the financial sector has been outperforming the broader market since the past one year. I am currently confused between investing in financial sector stocks individually or investing in an index mutual fund tracking a financial sector index. Can you please elaborate on the pros and cons of investing in an index fund tracking the financial sector?
Krishna Trilokcand Vasvani, Jaipur, Rajasthan.
Picking stocks individually vs. Index fund
Financial sectors stocks have outperformed the broader market in the past one year. There are multiple ways to invest in the financial sector chief among them is either picking financial sector stocks individually or investing in an index fund tracking a financial sector index. In India there are multiple indices tracking the financial sector such as nifty PSU banking index, nifty private bank index, S&P BSE BANKEX, etc. Amongst, index mutual funds, nifty financial services index is one of the most tracked index.
For the purposes of your question we will be restricting the scope of our answer to analysing investment in financial sector stocks individually vs. investing in an index mutual fund tracking nifty financial services index. Both options have their merits and demerits, and the right answer depends on the investor's goals, risk tolerance, and investment horizon.
Picking financial stock individually
Picking financial stocks individually means you are placing your bet on the performance of a few finance sector companies selected by you. Most investors will be able to research on less than 10 financial sector stocks and invest in two or three of them. This approach can be highly rewarding if the companies selected by you perform well, potentially offering higher returns than the market average.
However, it also comes with much higher risks. The banking sector is sensitive to economic changes, regulatory policies, and interest rate fluctuations. The stocks selected by you will not only be susceptible to these factors, but to other factors such as their own operational performance and governance.
Before picking financial stocks, investors should conduct thorough research, which includes analysing the companies’ financial statements, understanding their business model, assessing the quality of their management, and keeping abreast of industry trends and regulatory changes. This requires time, expertise, and a willingness to monitor the investment closely.
Index mutual fund tracking nifty financial services index
On the other hand, an index mutual fund tracking the nifty financial services Index offers a more diversified investment. Such a fund mirrors the composition and performance of the nifty financial services index, which includes a basket of stocks from the Indian financial services sector, not just banking but also other financial entities like insurance companies, non-banking financial companies (NBFCs), and housing finance firms.
The nifty financial services index serves as a barometer for the industry's performance. This index, which is a subset of the Nifty 50 and comprises 20 companies, encompasses a broad range of companies, including banks, financial institutions, insurance companies, and other financial services providers.
The top 10 constituents of the nifty financial services index are:
- HDFC Bank Ltd.
- ICICI Bank Ltd.
- State Bank of India Limited.
- Axis Bank Ltd.
- Kotak Mahindra Bank Ltd.
- Bajaj Finance Ltd.
- Bajaj Finserv Ltd.
- Shriram Finance Ltd.
- SBI Life Insurance Company Ltd.
- HDFC Life Insurance Company Ltd.
The diversification inherent in an index mutual fund helps spread the risk across different companies and sub-sectors, reducing the impact of any single stock's poor performance. Moreover, index funds are passively managed, which typically results in lower expense ratios compared to actively managed funds. This makes them a cost-effective option for investors who are looking for exposure to the financial services sector without the need to select individual stocks.
Nifty financial services index - How does it select stocks?
To be considered for inclusion in this index, there are specific eligibility criteria that companies must meet:
- The company should be listed on the National Stock Exchange (NSE).
- It should form a part of the Nifty 500 universe, which represents the top 500 companies by market capitalization on the NSE.
- The company should belong to the financial services sector.
- It is preferable, though not mandatory, for the company to be traded on NSE’s Futures & Options (F&O) segment.
The index is calculated using the free float market capitalization method, where the level of the index reflects the total market value of all the stocks in the index relative to a particular base market capitalization value. The nifty financial services index is rebalanced semi-annually, and it comprises 20 stocks that are selected based on their free float market capitalization within their respective sub-sectors.
Choosing between individual stock picking vs. Index fund
When deciding between picking a financial sector stock individually and an index mutual fund, investors should consider the following factors:
Risk tolerance: Are you comfortable with the volatility associated with 2-3 stocks, or do you prefer the relative stability of a well-diversified portfolio?
Investment horizon: Is your investment for the short term or long term? A small portfolio of 2-3 stocks may be suitable for those with a shorter horizon
Research and monitoring: Do you have the time and expertise to research and monitor individual stocks, or would you prefer a hands-off approach?
Costs: Are you mindful of the costs associated with managing your investments? Index funds often have lower fees than the costs incurred when trading individual stocks. If you are hiring a registered investment advisor for investing in stock individually it may cost you much more than investing in an index fund.
Advantages of investing in a mutual fund tracking nifty financials services index
Diversification within the financial sector:The nifty financial services index encompasses a wide range of companies within the financial sector, including banks, insurance companies, non-banking financial companies, and other financial services entities. By investing in a mutual fund that tracks this index, you gain exposure to a diversified portfolio of financial stocks, which can help mitigate risk while still capitalising on the growth potential of the sector.
Cost-effectiveness: Index funds are known for their lower expense ratios compared to actively managed funds. This cost-efficiency is a significant advantage, as lower costs can lead to higher net returns over time. By tracking an index, these funds avoid the higher fees associated with active management, making them an economical choice for investors.
Alignment with economic growth: The financial services sector is often closely aligned with the broader economic growth of a country. As the economy expands, so does the demand for financial services, from loans and credit facilities to insurance and investment products. A mutual fund tracking the nifty financial services index allows investors to potentially benefit from this economic progression.
Professional management and passive strategy: Despite being a passive investment, a mutual fund tracking the nifty financial services index is still managed by professional fund managers. These experts ensure that the fund's portfolio mirrors the index as closely as possible, thereby aiming to minimise tracking error and maintain the fund's performance in line with the index.
Liquidity: Mutual funds offer the advantage of liquidity, allowing investors to buy or sell their fund units with relative ease. This liquidity, combined with the typically lower volatility of index funds, makes them an attractive option for investors who value flexibility and stability.
In conclusion, there is no one-size-fits-all answer to whether one should invest in the financial sector by picking stocks individually or an index mutual fund tracking the nifty financial services index. However, if you are an individual engaged in full-time employment investing in an index mutual fund tracking the nifty financial services Index can help you in saving time which you will require for market research in case of investing in stock on your own.
Furthermore, investing in an index fund also frees you from:
(a) Day to day tracking of the stock market.
(b) Increasing or decreasing your allocation according to market conditions.
(c) Doing research in relation to stock selection, etc.
One should take into account his/her bandwidth and expertise before choosing either of the two options and then decide accordingly.
Disclaimer: Investing in mutual funds involves risks, including potential loss of principal. Please consult with a financial advisor before making any investment decisions.
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