The concept of index funds is old, but these funds have gained traction during the COVID-19 pandemic. This article focuses on various aspects concerning index funds.
What are index funds?
Index funds, also known as index-tracked or index-tied funds, are mutual funds imitating an index portfolio, like NSE Nifty 50 and S&P BSE Sensex. The primary objective of index funds is to track and emulate the performance of renowned indices. Since the asset allocation of the index fund and the underlying index is the same, the returns are also comparable.
Before discussing how index funds work, here are the top index funds in India. (Source – https://cleartax.in/s/best-index-funds-india)
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The top index funds in India
The principle behind index funds is that they do not outperform the market but track the index. Therefore, they are helpful to the investor in managing and balancing the risks in their investment portfolio. Secondly, index funds do not incur any expenses because they are passively managed funds.
The functioning of index funds
The functioning of index funds depends on which index it tracks. For example, if the index fund follows the NIFTY benchmark, its portfolio will consist of the fifty stocks comprising NIFTY in the same proportion. An index consists of a group of securities that define a market segment. The securities include equity-oriented instruments or bond market instruments.
Index funds are passively-managed funds because they follow a specific index. The fund manager decides the stock trading options depending on the specific composition of the indexed benchmark.
The index fund differs from the actively-managed funds because it does not strive to beat the benchmark but attempts to match its performance to that of the index. Therefore, the returns from index funds are comparatively less. The difference between the index and the fund performance is known as tracking error. The objective of the index fund is to keep the tracking error as low as possible.
Who can invest in index funds?
Any investment depends on your investment goals and risk preferences. So, index funds are ideal for those who are averse to taking risks and expect predictable returns. So, before investing in index funds, you can ask, ‘What are the investment alternatives?’ For example, index funds are ideal if you like participating in equities but are wary of their risks. However, if you want to earn good returns, the actively managed mutual funds are better.
The returns from index funds could match that of the actively managed funds in the short term. However, the actively managed mutual funds are better for long-term investments.
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Why is it beneficial to invest in index funds?
Index funds have their benefits.
- Generally, the investment is in blue-chip companies. Therefore, the investments are secure.
- The index funds are less susceptible to market fluctuations and are thus considered stable.
- The performance of the underlying indices like S&P BSE Sensex and NSE Nifty 50 has been excellent.
- Index funds have seen and survived the worst of challenges, including pandemics, geopolitical tensions, and recession.
The advantages of index funds
The advantages of investing in index funds are as follows
- Since index funds are passively managed, the expense ratio is comparatively lower than regular mutual funds.
- The asset allocation is generally stable and changes only when there is a change in the asset allocation of the underlying index.
- Since the fund manager does not trade securities frequently, the expense ratio is maintained.
- The investment is generally in top-rated companies. So, they are not subject to severe market fluctuations.
So, index funds are ideal for investors willing to bear small risks for earning restricted returns.
Things every investor should consider when investing in index funds
- Investment Costs – Index funds are passively managed funds and hence, have a lower expense ratio than the actively managed mutual funds. The fund managers do not have to formulate any specific investment strategy but follow the underlying index. For example, if two index funds follow NIFTY, the returns will be similar. The fund with a lower expense ratio generates higher returns.
- Tolerance to risks – Index funds follow a specific index and are less prone to volatility and market risks. Therefore, it is possible to generate good returns in index fund investments in a rallying market. However, if there is a market slump, index funds can lose value. Therefore, investors have to switch over to an actively managed mutual fund. Ideally, one should have a balanced portfolio of index funds and actively managed mutual funds.
- Returns factor – Actively managed mutual funds try to beat the benchmark and set new ones. However, index funds play it safe by following the performance of the underlying benchmark. Therefore, the returns on index funds are comparatively lower because of the tracking error. Accordingly, investors should study the market well and invest in index funds with the lowest tracking errors. They are the ones giving better results.
- Expanding investment horizon – Index funds can experience fluctuations in the short term. Therefore, they are ideal for investors willing to invest long term. For example, a 7-year investment horizon can earn a competitive return of 10% to 12%. Thus, index funds are best for investors with the patience to stick around for long.
You have many income-earning options like ‘Refer and earn apps’ and P2P lending platforms. However, they do not guarantee consistent returns like index funds. Therefore, investing in the top index funds in India should be the ideal answer to the question, What are investment alternatives?
We trust that we have explained the concept of index funds in detail.