An index fund is a mutual fund that performs similar to an index’s portfolio. They are also known as index-tied or index-tracked mutual funds. Index funds are popular among investors because they aim to replicate the performance of their underlying index, such as the Sensex or the Nifty. All of the stocks in these indices will be represented in their investment portfolio India. This theoretically ensures that the performance is identical to that of the index being tracked. Its main selling point is its low expense ratio. Because index funds are not actively managed, they have low expenses. They do not seek to outperform the market, but rather to follow an index.
When an index fund tracks a benchmark, such as the Nifty, its portfolio will contain the same 50 stocks as the Nifty, in the same proportions. An index is a collection of securities that define a market segment. These securities can be either bond market instruments or equity market instruments such as stocks. The BSE Sensex and NSE Nifty are two of India’s most popular indices. Index funds are classified as passive fund management because they track a specific index. The fund manager determines which stocks must be purchased and sold based on the composition of the underlying benchmark. Index funds, unlike actively managed funds, do not have a separate team of research analysts to identify opportunities and select stocks investment. Instead, index funds track an index.
While an actively managed fund strives to outperform its benchmark, the role of an index fund is to match the performance of its index. Index funds typically produce returns that are close to or equal to the benchmark. However, there may be a small difference in performance between the fund and the index. This is known as the tracking error. The fund manager must work to reduce the tracking error.
Five things to consider when investing in an Index fund
Tolerance to Risk: Because index funds replicate an index, they are less vulnerable to equity-related volatility and risks. If you want to generate high returns in a rising market, index funds are an excellent choice. During a market downturn, however, you will need to switch to actively managed funds. During a market downturn, index funds tend to lose value. As a result, it is recommended to have a mix of actively managed and Index funds in the Portfolio.
Individual Financial target: Equity funds can be ideal for long-term financial goals such as wealth creation or retirement planning. These funds, as a high risk-high return haven, are capable of generating enough wealth to allow you to retire early and pursue your life’s passion.
Return Factor: Index funds, as opposed to actively managed funds, passively track the performance of the underlying benchmark. These funds do not seek to outperform the benchmark, but rather to replicate its performance. However, due to tracking errors, the returns generated may not be on par with the index. Deviations from actual index returns are possible. As a result, before investing in an index fund, it is best to shortlist funds with the lowest tracking error. The lower the errors, the better the fund’s performance.
Cost of investment: Index funds typically have lower expense ratios than actively managed funds. Index funds’ portfolios are generally passively managed, and the fund manager is not required to devise any investment strategy in stock market. As a result, the expense ratio differs. If two index funds track the Nifty, their returns will be comparable. The expense ratio will be the only difference. The fund with the lower expense ratio will generate higher returns on investment.
Investment horizon: Index funds, in general, are appropriate for individuals with a long-term investment horizon. Typically, the fund experiences many fluctuations in the short run, which averages out over the long run, say, more than seven years, to generate returns in the 10% to 12% range. Those who invest in index funds must be willing to wait at least that long. Only then will the fund be able to perform to its full potential.
The decision to invest in a mutual fund is solely based on your risk tolerance and investment objectives. Index funds are ideal for risk-averse investors seeking predictable returns. In the short run, index funds’ returns may match those of actively managed funds. However, the actively managed fund outperforms in the long run. All it takes to invest in an Index fund is a Demat account and an online trading platform.