What are Index Funds?
As the name suggests, an Index Mutual Fund invests in stocks that imitate a stock market index like the NSE Nifty, BSE Sensex, etc. These are passively managed funds which means that the fund manager invests in the same securities as present in the underlying index in the same proportion and doesn’t change the portfolio composition. These funds endeavour to offer returns comparable to the index that they track.
How do Index Funds work?
Let’s say that an Index Fund is tracking the NSE Nifty Index. This fund will, therefore, have 50 stocks in its portfolio in similar proportions. Similarly, a broader market index, like the Nifty Total market Index will have around 750 stocks in its portfolio across market caps and sectors. An index can include equity and equity-related instruments along with bonds. The index fund ensures that it invests in all the securities that the index tracks.
While an actively managed mutual fund endeavors to outperform its underlying benchmark, an index fund, being passively managed, tries to match the returns offered by the underlying index.
Who should invest in an Index Fund?
Since Index Funds track a market index, the returns are approximately similar to those offered by the index. Hence, investors who prefer predictable returns and want to invest in the equity markets without taking a lot of risks prefer these funds. In an actively managed fund, the fund manager changes the composition of the portfolio based on his assessment of the possible performance of the underlying securities. This adds an element of risk to the portfolio. Since index funds are passively managed, such risks do not arise. However, the returns will not be far greater than those offered by the index. For investors seeking higher returns, actively managed equity funds are a better option.
Factors to consider before investing in Index Funds in India
Here are some important aspects that you must consider before investing in index funds in India:
Risks and Returns
Since index funds track a market index and are passively managed, they are less volatile than the actively managed equity funds. Hence, the risks are lower. During a market rally, index funds returns are good usually. However, it is usually recommended to switch your investments to actively managed equity funds during a market slump. Ideally, you should have a healthy mix of index funds and actively managed funds in your equity portfolio. Further, since the index funds endeavor to replicate the performance of the index, returns are similar to those of the index. However, one component that needs your attention is Tracking Error. Therefore, before investing in an index fund, you must look for one with the lowest tracking error.
Expense Ratio
Expense Ratio is a small percentage of the total assets of the fund charged by the fund house towards fund management services. One of the biggest USP of an index fund is its low expense ratio. Since the fund is passively managed, there is no need to create an investment strategy or research and find stocks for investing. This brings the fund management costs down leading to a lower expense ratio.