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Index Funds
Investors try to spread out their funds across various asset classes like equity, debt, real estate, gold, etc. Among the popular ways of reducing risks through equity investing is diversifying the equity portfolio. This is done by investing in shares of companies from different sectors and of different market capitalisations. And this is where the Index funds step in. Index funds were developed to address the challenges that investors face while choosing or selecting a basket of securities in line with their investing goals. In this article, we are going to explore and cover various types of index funds available in India, along with their advantages and a lot more.
What are Index Funds?
An index fund is a type of mutual fund scheme whose investment objective is to aim to track and replicate the composition and performance of an underlying index of securities, subject to tracking error. An index is something like a basket of securities, either stocks or debt instruments, representing some specific theme or category of the markets, such as NSE Nifty or BSE Sensex. Exchanges come out with different indices from time to time, which represent the different market segments and serve as a benchmark for several financial analyses. For example, the NIFTY 50 Index is representative of the top large-cap companies on the market and similarly, the NIFTY Small Cap 50 index represents the top 50 companies in the small-cap segment.
In an index fund investment, returns are replicated by adopting a passive investment approach. The same composition of the underlying selected index is maintained in a portfolio by a fund manager, who invests in the constituent securities and maintains proportionate weights without any alteration to the portfolio composition.
How do Index Funds Work?
Index funds adopt a passive investment approach. The fund's corpus is invested in the same securities and in the same proportion as found in the underlying index.
Stock indices undergo re-balancing, and they are re-constituted from time to time. Accordingly, the fund manager also re-aligns the portfolio composition of the fund by selling outgoing securities and buying incoming securities of the index. In doing so, index funds aim to earn appropriate returns subject to tracking errors.
For instance, a NIFTY Index Fund would invest in stocks of the companies coming under the NIFTY 50 Index in proportion to their weights in the index. Thereby, it aims to achieve a return equivalent to the benchmark NIFTY 50 index. For example, in case XYZ company has a 17.1% weightage in the NIFTY 50 index, their fund manager will allocate exactly 17.1% of the portfolio to the stocks of XYZ company and so on with the remaining stocks in the index.
The fund manager tries to replicate any changes that occur in the index. Corresponding changes in the weightage of a stock in an index also result in the modification of holdings by the fund manager in the index fund portfolio. If a stock gets removed from the index and a new stock takes up its place, the removed stock would be sold by the fund manager, and the new stock would be bought in the same proportion as is included in the index.
Why Invest in Index Funds?
Index funds benefit their investors in the following ways:
Reduced investing costs : The passive investment strategy makes it possible for one to get the benefit of experiencing low total expense ratios, which hold down the cost of investing.
Single access point to invest : Index funds provide an investor with a means to avail diversified exposure to an index's cross-section of securities through a single investment vehicle.
Hedging influence : The funds just track the index; therefore, there is no existing human bias in stock selection, making decisions not susceptible to 'active stock selection risk'.
Minimum investment amount : Index mutual funds provide broad portfolio access with a low minimum investment that is as low as Rs. 500.
Periodic rebalancing : An index fund allows market behaviour to drive stock selection through an index based on market sentiments. This means that you remain invested in the growing funds of the market through a passive investing approach.
Who Should Invest in Index Funds?
Index mutual funds are a suitable choice for the following types of investors:
Investors looking for ease in the investing process : Unlike the actively managed fund, an index fund does not require tracking. This makes it befitting for those short on time who want insights into their investments and are interested in index funds. By choosing index mutual funds, investors can enjoy an easy investment experience while still participating in the overall market performance.
Beginner-level investors : If you are seeking returns provided by the share market and do not want to incur more risk in the temptation of gaining a higher return, then index funds can be for you. Such funds mirror the performance of a market index, meaning the return is very close to what the market is experiencing. Therefore, index mutual funds are particularly helpful for new investors who want to gain market-linked returns.
Investors wishing to reduce active stock selections : Index funds remove human bias by mimicking an index based on pre-defined rules, allowing for unbiased investing. It is a way of minimising active stock selection risk. So, those who don’t want active stock selections on their own may choose to invest in index mutual funds.
Benefits of Index Funds in India
You will find many benefits of index mutual funds if you consider investing. Some benefits are:
Lower expense ratio : Usually index funds have lower expense ratios compared to actively managed mutual funds. This means you can invest more of your money and since the expense ratio is quite low, it may help you to gain potentially better returns.
Easy to manage : Index funds are easy to manage since it doesn't quietly change their allocation in assets. Once you invest in an index fund, the allocation stays the same unless you decide to change it or your manager is replaced.
Steps to Invest in Index Funds
Index fund investing is quite simple. To accomplish this, you may consider the following steps:
How Does One Select the Right Index Fund?/Factors to Consider Before Investing in Index Funds
Here are some of the key things to consider while investing in Index funds In India:
Risks and Returns
Index funds are less volatile compared to actively managed equity funds since index funds usually track a market index with a passive management practice. One usually is recommended to switch their investments to actively managed equity funds during a market slump.
Ideally, you should have a mix of index funds and actively managed funds in your equity portfolio. Further, index funds try to replicate the performance of the index, and therefore the returns are like that of the index. However, one component that requires your attention is tracking error. Therefore, before investing in an index fund, you must look for the one with the lowest tracking error.
Expense Ratio
The expense ratio is a small percentage of the total assets of the fund charged by the fund house towards management services. One of the USPs of an index fund is that it has a low expense ratio. Since the fund is managed passively, there is no planned investment strategy or research to find stocks for investment. This brings down the fund management costs, leading to a lower expense ratio.
Invest as Per Your Investment Plan
Index funds are suggested for an investment horizon of over 7 years. You could match these investments to every one of your long-term financial goals and remain invested in them for as long a time as you can.
Frequently Asked Questions
What are mutual funds?
What factors should I consider when selecting a mutual fund?
How to Invest in Mutual funds on Axis MF?
What type of mutual fund should I Invest in?
What is SIP in Mutual fund?
How quickly can I start investing in mutual funds through Axis MF?
Are there any fees or commissions associated with investing in mutual funds on Axis MF?
How do mutual funds get their returns?
Is there a minimum holding period for withdrawing from mutual funds?
What is minimum investment required to invest in mutual funds?
Frequently Asked Questions
How do index funds grow?
Index funds grow by tracking the performance of the underlying market or index they are designed to replicate. Investors benefit from the overall market's growth over time.
Is there any risk in index funds?
What are the limitations of index funds?
Are index funds good for the long term?
Do index funds pay capital gains?
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